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SOCIAL AND ECONOMIC

CHANGE MONOGRAPHS
25
www.isec.ac.in
Ashima Goyal
History of
Monetary Policy
in India Since
Independence
INSTITUTE FOR SOCIAL AND
ECONOMIC CHANGE
Bangalore
2012
Prof P R Brahmananda Memorial Research Award
SOCIAL AND ECONOMIC CHANGE MONOGRAPH SERIES
Number 25 January 2012
ISBN 81-7791-124-4
Series Editor: MEENAKSHI RAJEEV
© 2012, Copyright Reserved
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SOCIAL AND ECONOMIC
CHANGE MONOGRAPHS
History of Monetary Policy in India
since Independence
Ashima Goyal
Institute for Social and Economic Change
Bangalore
2012
25
Prof P R Brahmananda Memorial Research Award
Foreword
Monetary Policy was a subject quite dear to Professor P R Brahmananda
and therefore the experts’ choice of the subject for the first Professor Brahmananda
Memorial Research Award in the field of research was eminently appropriate. The
first award was given to Professor Ashima Goyal, who completed this monograph
with her strong academic acumen and in-depth research inputs. We are grateful to
Prof Ashima Goyal for undertaking this challenging task and completing it with
this exceptional monograph.
Monetary Policy has assumed greater importance in the Indian economy
and we have had many phases and interventions spanning decades. It is known
that tracking the history of monetary policy of India is not an easy task but the
careful fact-based analyses by Prof Ashima Goyal make it quite lucid reading.
Initially, in the import-substituting and restrictive growth scenario, operations of
the monetary policy were quite effective. The author traces all those monetary
policy initiatives during the first four decades after Independence. Subsequently,
the liberalisation and globalisation era exerted tremendous pressure on the
operations of the monetary policy. Added to this, the operations in global money
market and the ensuing global crisis exerted pressure on the tools of the monetary
policy and posed new challenges to the policy-makers. Prof Goyal discusses these
issues quite scholarly.
The monograph covers most of the major mile-stones in the development
of monetary policy in the post-Independence India. The author not only elaborates
on the justification but also describes the consequences of the steps taken. Initially,
Professor Goyal discusses major structural changes in the Indian economy and
the macro-economic indicators of the economy. Interestingly, she also looks at
these during the governance of different RBI Governors. This discussion is followed
by an elaboration on the international and national ideas about the working of the
monetary policy. The policy steps initiated over the past six decades are discussed
to give an overview of the operations of the monetary policy in the country.
I strongly feel that the monograph is very timely and a most appropriate
step in honour of the late Professor P R Brahmananda. We are grateful to the family
of the late Professor Brahmananda for the donation to initiate this research theme.
The help received from leading monetary economists in the award selection process,
like Professors V S Chitre, D M Nachane, Mihir Rakshit and Dr Y V Reddy, is
gratefully acknowledged. I am sure that this scholarly monograph by Professor
Ashima Goyal will serve as the most important landmark in the study of history of
monetary policy of India.
January 2012 R S Deshpande
Bangalore Director, ISEC
CONTENTS
List of Tables iii
List of Charts iii
Acknowledgement iv
I. ABSTRACT AND INTRODUCTION 1-2
II. STRUCTURE 3-11
1. Sectors 3
2. Growth and Inflation 5
3. Politics 7
4. Government Finances 9
III. IDEAS 12-24
1. Keynes Modified 12
2. Monetarism in the Aggregate 13
3. Globalisation: Ideas and Domestic Impact 16
4. New Keynesian Theories in Emerging Markets 19
IV. INSTITUTIONS 25-33
1. Precedents and Path Dependence 25
2. Strengthening Institutions 28
3. Openness, Markets and CB Autonomy 30
4. Bank Governors and Delegation in India 31
V. OUTCOMES 34-55
1. The Historical Trajectory 34
2. Excess Demand or Cost Shocks? 37
3. Openness, Inflows and Policy 40
4. Money Markets and Interest Rates 44
5. The Global Crisis, Response and Revelation 48
of Structure
6. Trends in Money and Credit 51
VI. CONCLUSION 56-57
REFERENCES 58-62
LIST OF TABLES
Table 1: Table 1: Sectoral Contribution to Growth 3
Table 2: Growth of GDP in Major Sectors 4
Table 3: Average Annual Inflation 5
Table 4: Savings, Investment and Consumption 7
Table 5: Center’s Fiscal Position 10
Table 6: Deficit of Central Government (Averages) 10
Table 7: Annual Average Macro Statistics in Tenures of 32
Reserve Bank Governors
Table 8: Monetary Policy Procedures 37
Table 9: Policy and Outcomes in High Inflation and other Years 38
Table 10: Average Annual Growth Rates 41
Table 11: Ratio to GDP Market Price 42
Table 12: Trends in Money 51
Table 13: Decadal Averages 52
Table 14: Trends in Credit 53
Table 15: Effects of Reserve Accumulation 54
LIST OF CHARTS
Chart 1: Year on Year Inflation Rate 6
Chart 2: Budgetary Deficit 6
Chart 3: Deficit of Central Government 8
Chart 4: Growth Rates 39
Chart 5: Inflation 39
Chart 6: Exchange Rate 43
Chart 7: Bank Rate 45
Chart 8: Call Money Rate 45
Chart 9: Annual Average 45
Chart 10: Daily: 2004-07 46
Chart 11: Daily: 2008-10 46
Chart 12: Transmission of RBI Repo Rates 46
iii
Acknowledgement
I thank the Professor P R Brahmananda Endowment Fund for the
Award, Dr R S Deshpande for his support, two referees for their very
encouraging response, Dr D M Nachane and Dr Y V Reddy for useful
discussions, TCA Srinivasa Raghavan for making an unpublished
manuscript on pre-independence monetary history available to me, Shruti
Tripathi and Reshma Aguiar for excellent research and secretarial assistance
respectively.
Ashima Goyal
iv
ABSTRACT
An SIIO paradigm, based on structure and ideas that become
engraved in institutions and affect outcomes, is developed to
examine and assesses monetary policy in India after
independence. Narrative history, data analysis, and reporting
of research demonstrate the dialectic between ideas and
structure. Exogenous supply shocks are used to identify policy
shocks and isolate their effects. It turns out policy was sometimes
exceedingly tight when the common understanding was of a
large monetary overhang. Fiscal dominance made policy
procyclical. But the three factors that cause a loss of monetary
autonomy—governments, markets and openness—are
moderating each other. Markets moderate fiscal profligacy and
global crises moderate markets and openness. Greater current
congruence between ideas and structure is improving
institutions and contributing to India’s better performance.
I. INTRODUCTION
The study examines and assesses monetary policy in India after
independence in the context of interplay between domestic structure and
external factors. Domestic structure includes economic and political
structure, the demands of growth, poverty reduction, financial inclusion and
the gradual development of institutions and markets. The external sector
includes the dominant ideas of the time and their change, shocks such as oil
and wars, dependence on foreign capital and the effect of greater opening
out. Structure and ideas become engraved in institutions that affect outcomes.
Instead of the structure, conduct, performance (SCP) paradigm used in the
industrial organization literature, this is a SIIO paradigm.
The approach is very much in the tradition set by Dr Brahmananda.
He had himself undertaken a monumental study of Money, Income and
Prices in 19
th
Century India (2001). But starting with his early work (Vakil
and Brahmananda 1956), a defining characteristic of his approach was to
refine analytical frameworks so that they became relevant for the analysis
of Indian structure
1
.
In the study, narrative history, data analysis, and reporting of
research are used to show the dialectic between ideas and structure. Policy
1
D M Nachane (2003) brings out, with great warmth and affection, both
Dr Brahmananda’s scholarship and his focus on relevance.
2 History of Monetary Policy in India
outcomes are explained in the framework developed. Given the six decades
over which the dialectic has played out, a broad brush approach is used that
focuses on the main trends, rather than the day-to-day policy decisions that
co-created the trends. But a flavour is given of intricate processes that
generate the cold numbers.
It is argued a greater congruence between ideas and structure in
recent times contributed to improvements in institutions and to India’s better
performance. Policy moved from struggling with scarcity to having to deal
with excess foreign exchange. Automatic financing of government deficits
gave way to more independence for the Reserve Bank, but political pressures
led to a uniquely Indian balancing between reducing inflation yet promoting
growth. The distinctive feature of the study is it is not an official history like
those currently available, but an independent academic work, that is closer
to the international and to Indian academic literature, while it draws on the
Indian experience largely from published materials, including official records.
The paper starts with a brief introduction to structural aspects that
impinge upon monetary policy in India in Section II. Section III follows the
development of international and national ideas about the working of
monetary policy; Section IV shows how institutions that were set up,
procedures and norms of practice that were established affected monetary
policy in India; the prior sections help to understand actual policy actions
and their outcomes analysed in Section V. Section VI has some concluding
remarks.
II. STRUCTURE
The most important aspect of India’s structure is the high population
density, and the high proportion of the population in less productive
occupations. The Hindu rate of growth (as Raj Krishna christened it) of
below 5 per cent per annum, for much of the period, meant that even in
2010 average per capita was only about 1,000 USD per capita and more
than 70 per cent of the population remained in rural areas.
1 Sectors
Steady development had brought down the share of agriculture
and allied activities in total income from 55 per cent in 1950-51 to 30 pre-
reform and 15 in 2010; but since the population dependent on agriculture
had not fallen commensurately, inequality increased. Poverty ratios had
fallen with growth, and literacy had increased, but given the one billion plus
population absolute numbers below the poverty line also remained at above
300 million, and illiteracy above 30 per cent. The proportion of population in
the most productive age group of 20-59 reached about 50 per cent by 2010.
This implied a large expansion in the work force needing to be equipped
with the appropriate skills
2
.
Table 1 gives the decadal averages, showing the changes in sectoral
composition. Over the years, the economy changed from being agriculture-
dominant to services-dominant. The share of industry doubled, but remained
low at about 20 per cent. Post-reform higher growth was driven by various
service sectors, industry also grew after 2000, but infrastructure, which
had done better in the previous two decades slowed (Table 2). Agriculture
had its best rate of growth in the ‘eighties.
Table 1: Sectoral Contribution to Growth
(Share of major sectors in GDP at factor cost)
At Constant Prices Industry Services Agriculture
1950-51 to 1959-60 11.62 34.38 47.58
1960-61 to 1969-70 15.02 39.14 40.41
1970-71 to 1979-80 16.74 42.18 36.24
1980-81 to 1989-90 18.66 46.3 31.97
1990-91 to 1999-00 20.09 51.51 26.01
2000-01 to 2009-10 19.69 60.29 18.23
2
The original source for the data processed in tables and charts, unless otherwise
mentioned, is the RBI and the CSO. Data is often conveniently available on their
websites.
4 History of Monetary Policy in India
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Structure 5
2 Growth and Inflation
Financial markets were quite active at the time of independence;
interest rates were market determined; an incipient bill market was also
developed. But according to the ideas of the time planning was extended to
the monetary and financial system also. To support planned development,
with the commanding heights for capital-intensive public sector projects,
the emphasis was on generating resources for public investment, allocating
resources to priority sectors, and expanding the reach of the formal financial
system.
After a good initial start with the 1
st
and 2
nd
five-year plans, the
system was unable to raise growth rates or moderate the supply-side shocks
the economy was subject to.
Table 3 shows decadal average inflation rates were dominated by
primary goods and fuel (FPLL) inflation. Liberalisation, and the effect of
competition from abroad, reduced primary good and manufacturing inflation
in the 2000s, but the severe international food and oil price shocks pushed it
up in the last years of the decade (Chart 1).
Table 3: Average Annual Inflation
Base 1982=100 WPI WPI WPI WPI WPI WPI CPI
(All (Primary (Food (Non- (FPLL) (Manufac (IW)
Commodi Goods) Articles) Food -turing)
-ties) Articles)
1953-54 to 1959-60 2.47 - 2.94 - 2.3 1.62 -
1960-61 to 1969-70 6.34 - 7.43 - 5.03 4.92 -
1970-71 to 1979-80 8.97 8.95 7.23 8.56 12.15 9.03 9.32
1980-81 to 1989-90 7.97 7.76 8.57 7.69 9.21 7.86 8.48
1990-91 to 1999-00 8.12 9.37 10.24 8.31 10.56 7.13 8.73
2000-01 to 2009-10 5.27 5.68 5.27 5.64 8.05 4.34 6.75
6 History of Monetary Policy in India
Ambitious projects in the second 5-year plan, and a paucity of
resources, made the government soon turn to deficit financing (Chart 2). In
these years the Reserve Bank of India (RBI) lost its initial independence
(see Section IV), and its primary responsibility became to find resources
for the Government expenditure. It always had a commitment to
developmental functions such as expanding credit to agriculture and other
priority sectors. In addition, in a democracy with a large number of poor
high inflation was not acceptable. Therefore tight control was kept on
aggregate money supply, but selective credit controls were used to direct
credit in line with Plan priorities (see Section V).

-15
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2005M1 2005M7 2006M1 2006M7 2007M1 2007M7 2008M1 2008M7 2009M1 2009M7
Chart 1: Year on Year Inflation Rate
WPI WPI(Primary Articles) WPI(FPLL) WPI(MFG)

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Chart 2: Budgetary Deficit
Structure 7
The push towards inclusive financial deepening, especially the
expansion of bank branches after nationalisation, probably contributed to
the sharp rise in the savings (GDS) GDP ratio in the 70s. Another large
jump came in the post-reform high growth period, and the growth rate of
GDS overtook that of capital formation (GDCF) and consumption (PFCE)
(Table 4). India has a healthy combination of savings to finance investment
and consumption to create demand. But the savings are poorly intermediated
through the financial sector, and even in 2010 less than half the population
had a bank account.
Table 4: Savings, Investment and Consumption
At current Prices GDCF PFCE GDS
Average Annual Growth Rate
1950-51 to 1959-60 8.06 5.17 8.67
1960-61 to 1969-70 12.87 9.61 13.69
1970-71 to 1979-80 15.15 10.46 15.28
1980-81 to 1989-90 17.06 13.58 16.04
1990-91 to 1999-00 16.09 14.34 16.62
2000-01 to 2009-10 14.83 11.07 16.18
As a Percentage of GDP at Market Price
1950-51 to 1959-60 11.30 90.58 9.85
1960-61 to 1969-70 14.31 83.38 12.44
1970-71 to 1979-80 17.88 77.64 17.88
1980-81 to 1989-90 21.41 71.62 19.40
1990-91 to 1999-00 24.56 64.30 23.24
2000-01 to 2009-10 31.87 59.08 29.16
3 Politics
A majoritarian democratic regime, such as India’s, has a bias towards
targeted transfers at the expense of public goods, compared to a regime
based on proportional voting. Political fragmentation, after the first twenty
years of Independence when the Congress party provided a stable
government, made matters worse. As the Congress lost dominance and
intense multi-party competition set in, populist schemes multiplied. With
multiple competing parties, swing votes become critical for winning in a
first-past-the-post system. After the oil shocks of the ’seventies, several
user charges for public goods were kept fixed, although costs were rising.
Subsidies, transfers and distortions increased while current and future
provision of public goods suffered.
8 History of Monetary Policy in India
By the 1980s, populist Central Sponsored Schemes (CSS) became
a way for the central government to directly reach the masses. New
schemes were announced every year, although targeting was poor and
waste and corruption proliferated. Since state elections were separated
from those at the Centre in 1971, frequent elections kept this pressure up
continually and harmed longer-term development. The first reaction of
new caste-based parties to the acquisition of power was consumption
transfers to their support groups, especially as belief in a vibrant future was
missing since the development policies of the past had not delivered growth.
Once in power they were concerned with “loot” in order to buy votes and
legislators in the future. Institutions of governance were undermined. In
the South where the caste-based movement was older, progressive reform,
emphasizing education and capacity building, was achieved (Goyal 2003).
The objective of providing government services at affordable prices
led to cross-subsidization both in the provision of specific products and
across government functions. Low price caps for many public goods led to
systematic incentives to lower quality and investment. Thus falling efficiency
and rising costs compounded the problem of low user charges, and prevented
a natural fall in prices from improvements in technology and organisation.
But where the government had monopoly power and was servicing the
rich, prices were raised much above costs of production, or indirect charges,
not obvious to voters, such as the prices of intermediate goods, were raised.
As the rich turned to private providers, revenue losses contributed to the
inability to service the poor adequately. The cross-subsidization was not

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Chart 3: Deficit of Central Government
Revenue Deficit Fiscal Deficit Primary Deficit
Structure 9
sufficient to cover costs. The choices made amounted to protecting the
poor through current transfers, rather than building their assets and human
capital, when it was the latter that was the sustainable option. This was a
rational social outcome because the rich could often escape imposts in the
long-term, and the poor had high discount rates and pessimistic growth
projections.
4 Government Finances
As these effects cumulated, the revenue deficit became positive.
That is, government consumption exceeded its income. Chart 3, shows that
the first year the revenue deficit became positive was 1980-81 and there
was never a surplus on current account after that. This is the amount the
government needs to borrow to finance its own consumption. The
government’s borrowing in any year to finance current and capital
expenditure net of tax and non-tax revenue is its fiscal deficit. The primary
deficit is the fiscal deficit minus interest payments. Since this is net of the
burden of servicing debts due to past borrowing it is a measure of current
borrowing, and of fresh addition to government debt. This, along with interest
payments, adds to government debt. Chart 3 shows the fiscal and primary
deficits began to fall after the reforms. The primary deficit even became
briefly negative, but given the burden of interest payments on past debt, the
revenue deficit could not fall until interest rates fell and tax buoyancy was
established in 2003. All three deficits shot up again with the fiscal stimulus
after the global financial crisis.
In the early years the only deficit concept used was that of budget
deficit (Chart 2). This was the change in outstanding treasury bills (T bills),
Government deposits and other cash balances with the RBI. The budget
deficit underestimated the monetary impact of the deficit since it did not
include RBI holdings of dated Government securities (Gsecs). The RBI
largely held the treasury bills. To the extent they were held by banks their
monetary impact was reduced. RBI credit to the government gives the
correct monetary impact of fiscal operations. After 1996, when automatic
monetization of the deficit was reduced, and government funding by banks
increased, the budget deficit falls (Chart 2).
As fund constraints appeared, it was easiest to postpone investment
plans. This strategy continued in the post-reform period. Table 5 shows the
trend reduction in capital expenditure compared to revenue expenditure,
and the sharp fall in capital expenditure in the post reform period. This
allowed some improvement in the fiscal and primary deficit that was specially
10 History of Monetary Policy in India
marked after 2000 (Table 6), a period of tax buoyancy from reform and
higher growth. Fiscal responsibility legislation also contributed, but was
overturned by the global crisis. The revenue deficit, however, remained
high as well-entrenched populist expenditures became difficult to cut. There
was an argument that some expenditures essential to build human capacity
were classified as current not capital expenditure. The government
accumulated debt both since it was borrowing for consumption, it was earning
very low returns on its investments, and its expenditures were not successful
for a long time in improving growth and taxes. Expenditures once
implemented set in self-sustaining dynamics partly by creating interest groups
or constituencies they favoured.
Table 5: Center’s Fiscal Position
(As a percentage of GDP at Current Market Price)
Revenue Tax Non Tax Total Revenue Capital
Receipt Revenue Revenue Expendi Expendi Expendi
-ture -ture -ture
1950-51 to 1959-60 - 4.5 - 7.14 3.75 3.39
1960-61 to 1969-70 - 6.7 - 12.32 5.87 6.46
1970-71 to 1979-80 1067 8.69 2.2 14.62 8.62 6
1980-81 to 1989-90 12.56 9.96 2.7 17.84 11.68 6.16
1990-91 to 1999-00 12.21 9.19 2.93 15.7 12.28 3.41
2000-01 to 2009-10 12.9 10.01 2.99 15.4 12.97 2.49
Decadal Growth Rate
1950-51 to 1959-60 8.5 14.55 9.06 24.91
1960-61 to 1969-70 13.72 13.52 15.22 12.34
1970-71 to 1979-80 15.44 15.6 14.4 14.25 16.25 12.14
1980-81 to 1989-90 16.41 15.79 19.41 17.31 18.56 15.05
1990-91 to 1999-00 13.85 12.98 17.18 12.43 14.53 6.37
2000-01 to 2009-10 13.06 14.47 10.2 13.29 14.01 13.06
Table 6: Deficit of Central Government (Averages)
(As a Percentage of GDP at Current Market Price)
Revenue deficit Fiscal deficit Primary Deficit
1970-71 to 1979-80 -0.12 3.9 2.4
1980-81 to 1989-90 1.9 6.8 4.1
1990-91 to 1999-00 3.1 5.1 1.6
2000-01 to 2009-10 3.34 4.8 0.8
Structure 11
In the more recent period, as growth creates more opportunities
for the people, delivery and governance have begun to matter for electoral
performance. Even as monetary policy got some degrees of freedom from
fiscal and legislative improvements, large inflows after reforms created
new constraints. After this brief review of the structure within which
monetary policy had to operate, we turn to the ideas that influenced policy.
III. IDEAS
India may have become a closed economy for much of the period,
but it has always been quite open to global academic ideas. The dialectic
between these and structure, needs, and the domestic political and economic
debate affected policies followed.
1 Keynes Modified
The 50s were the period when Keynesian ideas dominated.
Especially following the Great Depression, Government expenditure was
thought to be the dominant macroeconomic tool. But the Indian debate was
more nuanced. VKRV Rao (1952) argued that pervasive supply bottlenecks
could be expected to make demand stimuli ineffective in a country like
India. It was Government investment that was to take the lead in reliving
supply bottlenecks through the Plan expenditures. Financing these
expenditures was an obvious concern. Indian policy followed Keynesian
ideas in giving government expenditure pride of place, with monetary policy
to support it. But the expenditure was to expand supply rather than create
demand. Policy was also Keynesian in giving priority to quantity adjustment
and intervention over price. Monetarists tended to favour the use of markets
with the role of the government restricted to creating an enabling environment
for the private sector; Keynesians were more interventionist—favouring
discretionary monetary and fiscal policies.
From the beginning RBI was committed to development. In the
context of large planned expenditure it was natural to emphasise credit and
its allocation to productive uses. But ensuring credit availability for the
Government and priority sectors, while meeting aggregate targets, meant
restricting credit to other sectors. In the beginning interest rates were market
determined, but market allocation was discounted in favour of rationing
quantities. Among recommendations of the influential UK Radcliffe
committee (1958), which provided support for these policies, were that
government debt and market liquidity management should be the focus of
monetary policy; and too large interest rate variations disturb markets. A
variety of devices were used to intervene in credit allocation. Apart from
general credit guidelines to direct bank credit to priority sectors; selective
credit controls were used, for example, to limit advances against certain
commodities to mitigate speculative hoarding. But at the same time banks
were forced to finance the large credit needs of the government food
procurement and distribution system.
Ideas 13
Following the USSR model and the ideas of Mahalanobis the plans
favoured a big push to develop indigenous heavy industry. Vakil and
Brahmananda (1956) pointed out early that in an economy like India, the
critical constraint was likely to be wage goods, requiring focus on agriculture.
They noted that whereas in a developed country the rate of growth of
capital equals that of population, and gives its rate of growth, in an
underdeveloped country the potential workforce exceeds capital stock.
Development, that raises per capita incomes, must involve a period where
the rate of growth exceeds that of population; the constraint that prevents
this, and sustains underemployment, is the supply of wage goods. Structural
rigidities did influence early thinking at the RBI (Pendharkar and
Narasimham 1966), but it led to quantitative credit allocation over the use
of general interest rate instruments in order to encourage development
activity and lower the cost of Government borrowing. A satisfactory
combination of key monetary and structural features has proved elusive in
Indian Keynesian-Structuralist or Monetarist models
3
.
The inward-looking import-substituting approach led to a severe
foreign exchange constraint. The foreign exchange regulation act 1974
was used to implement severe rationing of foreign exchange, with heavy
regulation of markets. Neglect of the wage goods constraint in planning
exercises meant inflation soon surfaced. But the response to this was
monetary. The acceptance of the economy as supply and not demand
constrained, together with the political sensitivity to inflation, meant
restriction on aggregate money supply growth was regarded as the answer
to inflation. It was also regarded as the answer to widening government
deficits. Increasing the statutory liquidity and compulsory reserve ratios of
commercial banks both financed government spending and restricted
aggregate money supply growth even as reserve bank credit to the
government continued to increase.
2 Monetarism in the Aggregate
If money, following Keynes, was regarded as having limited impact
on the real sector because of the liquidity trap and low demand elasticities,
the quantity theory of money linking the money supply to the price level
3
Krishnamurthy and Pandit (2005), Rakshit (2009), and Balakrishnan (1994) are
fine examples of structuralist thinking in the Indian context. Jadhav (1990) surveys
monetary models.
14 History of Monetary Policy in India
was largely accepted as the analytical framework underpinning the supply
of money
4
. Given reasonable predictability of money demand and the money
multiplier, monetary targeting was feasible if reserve money could be
controlled. Rising income elasticity of money demand could be factored in.
Given automatic financing of the budget deficit, raising the reserve ratios
was a way to control reserve money.
Estimations largely gave a stable money demand
5
, when enhanced
to include variables relevant in the Indian context, such as relative shares
of agriculture and non-agricultural output and the degree of monetization
6
.
Interest elasticity was low
7
, and income elasticity of demand for broad
money was about 1.5 to 2 (Gupta 1972, 1976; Vasudevan 1977). On the
supply side, the money multiplier (that multiplied the reserve money to
generate the money stock) was also stable. So it was thought possible to
derive an acceptable rate of growth of money supply by adjusting the growth
of reserve money by changes in the reserve ratio. For money supply to be
used to determine prices the first step is for the RBI to be able to control
money supply.
The money multiplier shows how broad money (M) can be created
as a multiple of base or high-powered money (H) given the currency deposit
(C/D) and bank reserves to deposit ratio (R/D). The multiplier decreases
4
In Irving Fisher’s version the quantity theory of money is written as MV=PY.
With constant velocity (V) and output (Y) at full employment, there is a one-to-
one relation of money supply (M) and the price level (P). Velocity would change
with the factors affecting the demand for money such as income and the nominal
interest rate. But predictable or stable changes in money demand could be
factored in to arrive at money supply targets.
5
As late as 1995, Rao and Singh argued that in spite of the overwhelming
international evidence on instability of money demand, Indian money, income
and a relevant interest rate were cointegrated, demonstrating long-run stability.
Even so, their view was that targeting of nominal income, or velocity, is superior
to targeting some monetary aggregate, since velocity can be derived
independently or residually, without trying to invert a questionable money
demand schedule.
6
Brahmananda’s (2001) monetary history was based on the quantity theory of
money following Friedman and Schwartz’s (1971) famous US history, but he
modified it to suit 19
th
century India, for example, by including an index of rainfall
as a determinant of the price level, and an index of monetization as a determinant
of velocity.
7
This was not surprising given that markets were suppressed. Pre-independence
studies had found significant interest elasticities (Anjaneyulu et al 2010).
Ideas 15
with both, since both decrease the credit banks can generate from a given
base
8
. In the seventies the RBI followed a balance sheet approach for
determining the components of money supply. This assumed the money
multiplier to be constant even in incremental terms. But C/D can be expected
to fall, for example, as bank branches rise. An adjusted multiplier corrects
for changes in cash reserves.
A number of authors sought to obtain more accurate predictions of
the money multiplier and improve the analytical understanding of money
supply determination (Gupta 1976, Singh et al 1982, Rangarajan and Singh
1984). Forecasting exercises included Rao, Venkatachalam and Vasudevan
(1981); Chitre (1986), Nachane and Ray (1989). The studies were an
important policy input. To target the money stock from a given base or
high-powered money, it was necessary to predict the money multiplier, so
that bank’s contribution to raising money supply could be quantified.
But macroeconomic variables are determined in a complex
interactive process. The studies did not adequately analyse the interactions
between the players who determine money supply. They ignored feedback,
simultaneous equation bias and identification problems. Even in 1959 banks
found legitimate ways to expand credit to meet rising demand despite higher
reserve requirements. They reduced cash in hand and excess balances
with the RBI, sold Gsecs (dated government securities), maintained large
outstandings on RBI accommodation, thus liquidating investments rather
than reducing advances as they were expected to. The RBI’s response
was to make access to its financing temporary to try and close loopholes
(Balachandran 1998 pp.79-80).
If banks managed some autonomy to maximise profits even in a
regime of direct credit controls, then these strategies can be expected to
dominate in a liberalised era. Money demand will become unstable as close
financial substitutes develop. Although loans create deposits, loans are
determined both by supply and demand. They depend on profit maximisation
by banks, and on RBI monetary policy that changes base money.
8
M=mH, where m is derived from the two identities M=C+D and H=C+R by
dividing the first from the second, and then dividing the numerator and
denominator by 1/D to get M= ((1+C/D)/(R/D +C/D)) H (Goodhart 2007). The
multiplier can also be written as m= [(D/R)(1+D/C) / (D/R + D/C)] by multiplying
the right side by [(D/CR) / (D/CR)]. The multiplier reduces when (D/R) or (D/C)
falls.
16 History of Monetary Policy in India
Dash and Goyal (2000) found money supply to be neither fully
endogenous, nor fully controlled in a new specification employed to test for
the degree of endogeneity of commercial bank credit, and its response to
structural variables relevant to the Indian context. They used the variable
M-H to identify money supply in a single equation, and disentangle the
contribution of the Central and the Commercial banks to the money supply
process over 1960-61 to 1992-93. They found bank credit reacted more to
financial variables and had dissimilar responses to food and manufacturing
prices and output. Credit turned out to be the endogenous outcome of
incentives facing agents. But in the data set, as interest rates were
imperfectly flexible, a range of price variables carried these incentives.
Whenever incentives to expand credit were high enough, banks found ways
around a variety of quantitative controls. They suggested price bubbles in
assets that lead to expansions in broad money could be better controlled
through tax-based regulation.
Although the RBI was able to affect base money, banks were able
to circumvent controls and expand credit when there were profits to be
made. Money supply had been somewhat exogenous, but fundamental
changes were occurring that made it more endogenous.
3 Globalisation: Ideas and Domestic Impact
Liberalisation and deepening financial markets made monetary policy
more effective and faster so that its use dominated macro stabilisation
from the 1980s. In the seventies the developed world moved to the float as
the dollar was delinked from gold, and gradually began to open capital
accounts.
Ricardian equivalence type arguments suggested private actions
would counter fiscal policy. For example, if government spent more,
taxpayers foreseeing a rise in future taxes would save more. This would
reduce the effect of government spending on demand. Long lags and political
constraints on fiscal policy were also being recognized as weakening fiscal
policy (Blanchard et al 2010). Markets were dominating governments and
price adjustments were dominating quantity adjustments, once again. The
instruments Central Banks (CBs) were using worldwide were interest rates.
The classical neutrality of money doctrine held that real interest rates were
determined by productivity and invariant to policy. Sargeant showed that an
interest rate instrument could make the system unstable. But these results
were shown to hold only if money was the only nominal standard. Sticky
wages and prices create an alternative that fixes nominal variables, and
Ideas 17
allow real interest rates to be influenced by policy for considerable periods.
Moreover, an interest rate rule that responded to macroeconomic variables
such as output and inflation gaps would be stable (Goodhart 2007).
As globalisation and financial innovations occur, significant interest
rate effects on domestic expenditures can be expected. Deeper financial
markets spread effects more widely. Interest rates play a larger role in the
transmission of monetary policy, and become the natural instrument of
monetary policy, although other channels of transmission, such as credit,
continue to be important. First, interest rates become more flexible and
responsive to CB intervention; second, the interest rate becomes a more
sensitive and fast signal of potential imbalances; third, demand for broad
money becomes unstable and enhancement in its supply from commercial
banks more flexible, so that targeting monetary aggregates becomes difficult,
and the attempt causes high volatility in interest rates; and fourth, the size
of foreign exchange, bond, equity and other asset markets rises. These
markets are very sensitive to interest rates. Now forward-looking behaviour
becomes more important and markets try to guess the CB’s response to
uncertainty and to shocks. Thus, transparency becomes a major issue. As
markets develop, the reason most CB’s start targeting interest rates is it
becomes necessary for market stability. A fractional banking system and
leveraged financial sector must have funds available whenever required in
order to function. It is necessary for the operation of interbank markets.
In India, however, the entire interest rate structure was still
administered, and markets underdeveloped as quantity rationing was in force,
so estimated interest elasticities of aggregate and money demand were
low. There was an argument that interest elasticity would be low in India
given the dualistic structure and limited reach of the modern financial sector
(Rakshit 2009). But the deleterious effects of quantitative controls were
beginning to be recognised. The perception that India was stuck at a low
one percent per capita growth while countries that had opened out in the
60s, such as South Korea, were doing much better was becoming common.
The Chakravarty Committee (RBI 1984) set up to review the working of
the monetary system wrote:
“…there does appear to be a strong case for greater reliance on
the interest rate instrument with a view to promoting the effective use of
credit, and in short-term monetary management. Over the years quantitative
controls on credit have increasingly borne the major burden of adjustment
required under anti-inflationary policies and have in the process given rise
to distortions in credit allocations at the micro level (pp. 161-2).”
18 History of Monetary Policy in India
Although it opted for an overall monetary targeting approach the
committee did warn that in an economy such as India with structural rigidities,
supply shocks and structural changes, a monetary growth rate must not be
mechanically implemented, but should be seen rather as an indicative,
flexible, target range. It suggested a range around 14 per cent for broad
money growth, based on an average output growth of 5 per cent, inflation
at 4 per cent, and income elasticity of broad money demand of 2.
It suggested a greater role for the interest rate in influencing the
demand for credit, thus reducing the sole reliance on rationing the supply of
credit, and allowing more productive credit allocation
9
. It advocated more
market holding of treasury bills (for short term finance) and Gsecs. A retail
market for Gsecs was also to be encouraged. These alternative avenues
for government borrowing were expected to give the RBI greater freedom
to use open market operations (OMOs), or sale and purchase of Gsecs
both outright and repos, to control reserve money. As interest rates rose a
fall in capital value would militate against higher voluntary holdings, so it
was suggested the valuation of Gsecs held to satisfy SLR be based on
purchase price and not on market value.
Narasimham Committee (RBI 1991) echoed these concerns, as
did the working group on the money market (RBI 1987).
“The committee is of the view that the SLR instrument should be
deployed in conformity with the original intention of regarding it as a
prudential requirement and not be viewed as a major instrument for financing
the public sector (RBI 1991, p. iv)” and the next recommendation on p. v
“… proposes that the Reserve Bank consider progressively reducing the
cash reserve ratio from its present high level. With the deregulation of
interest rates there would be more scope for the use of open market
operations by the Reserve Bank with correspondingly less emphasis on
variations in the cash reserve ratio.”
Low returns from deficit financed public investment and growth
stagnation in a protected economy contributed to worsening deficits, and
accumulating debt. This faltering of fiscal policy in India was bolstered by
international changes in dominant ideas.
While the original Keynesian position had been that fiscal policy
was generally more effective than monetary policy; the New Keynesian
view was that interest rates were effective in closing the output gap, given
9
Even banks used a system of cash credit rather than bills and loans to finance
working capital, which reduced their supervision of the end use of credit.
Ideas 19
wage-price rigidities, except in extreme liquidity traps. Even the original
Monetarist position was misunderstood. Friedman’s famous quote about
money being a veil and having no effect on the real sector has an important
rider:
“Money is a veil. The “real” forces are the capabilities of the people,
their industry and ingenuity, the resources they command, their mode of
economic and political organization, and the like (Friedman and Schwartz
1971, p 606)….Perfectly true. Yet also somewhat misleading, unless we
recognize that there is hardly a contrivance man possesses which can do
more damage to society when it goes amiss (p 607).” This was to be
expected from a monetary history that covered the Great Depression.
They also identified the fundamental reasons that create problems
from both too tight and too loose monetary policies. Too tight policies can
destroy the financial system since:
“Each bank thinks it can determine how much of its assets it can
hold in the form of currency, plus deposits at the Federal Reserve Banks, to
meet legal reserve requirements and for precautionary purposes. Yet the
total amount available for all banks to hold is outside the control of all banks
together (p 607).”
But too loose can destroy confidence in the currency:
“…that common and widely accepted medium of exchange is, at
bottom, a social convention which owes its very existence to the mutual
acceptance of what from one point of view is a fiction”.
The monetary squeeze was particularly tight in India after the oil
shocks of the ’seventies and had a high output cost. But a better synthesis
of Keynesian and Monetarist ideas was becoming feasible.
4 New Keynesian Theories in Emerging Markets
The New Keynesian school (Clarida et al 1999, 2001; Woodford
2003) demonstrates how monetary policy can work effectively through an
interest rate instrument that reacts to expected inflation. Results are based
on simple IS (investment equals savings) curve and Phillips curve (PC),
derived from rigorous optimization by agents with foresight. They differ
from standard formulations in the strong theoretical foundations, which make
them robust to policy shocks
10
, and give them forward-looking behaviour.
10
Lucas had critiqued early Keynesian models. Since they were not derived from
individual behaviour parameters could change with policy shocks, making them
unreliable for the analysis of policy.
20 History of Monetary Policy in India
The IS curve relates the output gap, or excess demand, inversely to the real
interest rate, positively to expected future demand and to a positive demand
shock. The PC curve relates inflation positively to the output gap, to future
expected inflation and a cost-push or supply shock. The output gap is defined
as the gap between actual and potential output. The PC relates inflation to
the output gap rather than unemployment, and to cost-push. This, and the
explicit modeling of relevant rigidities and distortions, makes it relevant to
Indian conditions. Even though it is difficult to measure unemployment, the
output gap can be defined for India. The idea of potential output and expected
future changes in it are useful for an economy undertaking structural reform.
Second, cost-push factors play a dominant role in inflation (Goyal 2002).
Such a PC is derived assuming a certain probability that administered
and other prices will remain fixed in any period. When a price is varied, it is
set as a function of the expected future marginal cost. A proportionate
relationship is assumed between the output gap and marginal cost. A cost
shock, then, is anything that disturbs this relationship. Such deviations can
occur due to administered prices, wage expectations, mark-up, exchange
rate shocks, infrastructure bottlenecks and rising transaction costs in an
emerging market. Some of these shocks affect average rather than marginal
costs since they are independent of activity at the margin. For example,
hiring more labour does not affect an administered price, but costs rise at
all levels of activity when the price rises. Since an administered price
increase is seldom reversed it raises future costs and is factored into the
pricing of sticky-price goods today.
When cost-push is zero only current and future demand causes
inflation. The CB can then vary interest rates to set excess demand to zero
for all time and lower inflation with no cost in terms of output, which remains
at its potential. A fall in output is required to lower inflation only if cost-push
is positive. So a short-run trade-off between inflation and output variability
arises only if there is positive cost-push inflation.
In mature economies, the modern macroeconomic approach
focuses on employment. In this class of models labour is the key output
driver (Woodford 2003). Capital is a produced means of production. In an
open economy resource bottlenecks are easier to alleviate. But even while
following that approach, in emerging markets (EMs), the large informal
sector is relegated to development economics. But once a populous EM
crosses a critical threshold and high catch-up growth is established, higher
labour mobility blurs the distinction between formal and informal sectors. A
macroeconomics of the aggregate economy becomes both necessary and
feasible. In labour-surplus economies established on a catch-up growth
Ideas 21
path, capital is available to equip labour and raise its productivity. Savings
rise with growth and capital flows in with greater openness.
So the longer-run aggregate supply (LAS) or PC is elastic (Figure
1). But inefficiencies, distortions and cost shocks push aggregate supply
upwards, over an entire range, rather than only at full employment, since
that is not reached at current output ranges and output can increase. The
LAS becomes vertical only as the economy matures and full productive
employment is reached. With such a structure, demand has a greater impact
on output and supply on inflation. This is the sense in which the economy is
supply constrained (Goyal 2011a, 2012). This framework differs from the
early idea that output cannot be demand determined in a developing economy
because of supply bottlenecks (Rao 1952). Here output is demand
determined but the supply-side raises costs. It also differs from the structural
school that while industrial output is demand determined agricultural output
is fixed at a time period. The difference arises because in an open economy
supply bottlenecks are easier to alleviate. Even agricultural commodities
can be imported, and the share of agriculture shrinks.
Figure 1: Aggregate demand and supply
Even so, the food price wage cycle is an important mechanism
propagating price shocks and creating inflationary expectations in India,
given low per capita incomes, and the large share of food in the consumption
basket. If markets are perfectly clearing and prices and wages are flexible,
then a fall in one price balances a rise in another with no effect on the
LAS
0
AD
0
Inflation
Output
AD
1
LAS
1
22 History of Monetary Policy in India
aggregate price level. But prices and wages rise more easily than they fall.
So, a rise in a critical price raises wages and therefore other prices,
generating inflation. Some relative prices, among them food prices and the
exchange rate, have more of such an impact. Food prices are critical for
inflation in India and, since international food inflation now influences
domestic, the exchange rate becomes relevant.
Political pressures from farmers push up farm support prices, with
consumption subsidies also going up. But these are inadequate due to
corruption and failures of targeting, so nominal wages rise with a lag pushing
up costs and generating second round inflation from a temporary supply
shock. This political economy indexes wages informally to food price
inflation. Political support also raises wages through minimum wages and
employment schemes such as MGNREGA. If the rise in subsistence wages
exceeds that in agricultural productivity, prices in turn rise, propagating
inflation. This happened after 2008 with MGNREGA as States competed
with each other in raising minimum wages since the Centre was footing the
bill. Given an exit option, workers’ could extract large jumps in wages.
Other types of populist policies that gave short-term subsidies but raised
hidden or indirect costs also contributed to cost-push. For example, neglected
infrastructure and poor public services increase costs.
Rigorous empirical tests based on structural vector autoregression
(VAR), time series causality, Generalized Method of Moments (GMM)
regressions of aggregate demand (AD) and aggregate supply (AS), and
calibrations in a Dynamic Stochastic General Equilibrium (DSGE) model
for the Indian economy support the elastic longer-run supply and the
dominance of supply shocks (Goyal 2011b, 2008a, 2005). The sustained
food inflation since 2008 led to some analysis of supply side factors (Gokarn,
2011; Mohanty, 2010). Joshi and Little (1994) have long argued that supply-
side responses have been neglected in Indian macroeconomic policy.
Under a positive cost shock, forcing an immediate reduction in
inflation would have a cost in terms of output foregone, which is especially
high with the above structure of AD and AS. Even with these structural
inflation drivers monetary accommodation is required to sustain inflation
and inflation expectations. But, with such a structure, even if some type of
inflation targeting was to be considered, only flexible inflation forecast
targeting with a positive weight to output stabilization maybe applicable.
To be able to apply inflation forecast targeting the CB has to first
establish that it is able to forecast inflation. In an EM, a monetary conditions’
index can be a precursor or complement to more formal inflation forecasting.
It is a weighted set of variables that affect aggregate demand. The set and
Ideas 23
weights vary across countries but include money and credit aggregates,
short-term interest rates, exchange rates and their fluctuations, direct
measures of domestic inflation, commodity prices, wages and even some
real variables such as capacity utilisation. India moved to such a regime in
1998.
Greater model uncertainty, and more backward-looking behaviour
in EMs leads to making less than full use of forward-looking behavior in
designing policy, in order to collect more information as well as lower asset-
price volatility. The short-term interest rate mainly affects capital flows,
exchange rates, and other asset prices. It is the longer-term interest rates
that affect aggregate demand. Smoothing short-term interest rates can lower
volatility in asset prices and yet allow the CB to directly affect demand
through the long-term rate. If the short-term interest rate is expected to
rise in the future, for example, the long-term rate will rise even more. So
the long-term rate can be affected with a smaller current change in the
short-term rate. But markets need to be surprised sometimes to prevent
over-leverage and excessive risk-taking.
With flexible inflation forecast or zone targeting, sharp changes in
interest rates are not required. It allows the discovery of potential output.
In an EM, there is a high degree of uncertainty attached to the latter, and it
changes more as reforms raise efficiency. With a flexible target, changes
in potential output reveal themselves. If inflation does not rise even as
output exceeds the expected potential, the potential must have risen.
Focusing on core inflation allows the first round effects of supply shocks to
be excluded from the target. Escape clauses can be built in for very large
supply shocks. Core inflation exempts volatile prices such as food and oil,
and therefore captures persistent demand-driven inflation the CB can affect.
However, headline inflation impacts the consumer, and if it becomes
persistent, it cannot be ignored.
In a small open economy, monetary policy transmission depends
also on the exchange rate channel. The lag from the exchange rate to
consumer prices is the shortest (Svensson 2000), especially if commodities
dominate imports. In a typical EM, the effect of the exchange rate on
inflation and capital flows and its role as an asset-price dominate. In these
circumstances, varying the nominal exchange rate in a target band around
the real exchange rate can make it feasible to smooth the nominal interest
rate instrument and achieve the desired intermediate target real interest
rate. If two-way movement of the nominal exchange rate is synchronized
with temporary supply shocks, and the exchange rate appreciates with a
negative supply shock, food and intermediate goods prices fall. This serves
24 History of Monetary Policy in India
to pre-empt the effect of temporary supply shocks on the domestic price-
wage process
11
. Building in a rule whereby there is an automatic announced
response to an expected supply shock avoids the tendency to do nothing
until it becomes necessary to over-react. Actions linked to exogenous shocks
avoid moral hazard. Two-way movement of the exchange rate also
encourages hedging thus reducing risk and developing foreign exchange
markets. It also keeps the real exchange rate near equilibrium values
preventing large and distorting deviation from fundamentals. There is
evidence that while currency crises adversely affect trade, limited fluctuation
in exchange rates do not have a large effect on trade. If limited volatility
helps prevent crises and lower interest rates, it may even benefit trade.
Thus forward-looking monetary policy can use its knowledge of
structure to abort the inflationary process. During a catch-up period of
rapid productivity growth potential output exceeds output. As supply shocks
are the dominant source of inflation, optimal policy should aim to achieve
an inflation target only over the medium-term by which time temporary
supply shocks have petered out, or been countered by exchange rate policy,
changes in tax rates, or improvement in efficiencies. Flexible inflation
targeting itself will prevent the inflationary wage-price expectations from
setting in that can imply a permanent upward shift in the supply curve from
a temporary supply shock. Monetary policy has to tighten only if there is
excess demand.
In the international experience inflation targeting has been combined
with an independent CB. Is this a pre-requisite in India?
11
In typical closed economy structuralist models agricultural markets were price
clearing with quantities given, while quantities adjusted in non-agricultural
markets. Therefore money supply could affect food prices. But in an open
economy, agricultural supplies are not fixed even in the short period since imports
are possible (Goyal 2004). Now the exchange rate affects food prices (Goyal
2010).
IV. INSTITUTIONS
In a democracy CBs are responsible for monetary and financial
stability, but the government is subject to the pressures of election. Therefore
the latter often forces the CB to try to raise output and employment. Once
workers have made their work decisions based on expected wages, if the
CB creates surprise inflation, this lowers real wages and unemployment
since firms are then willing to employ larger numbers. Workers are tricked
into working for lower wages. But over time such behaviour becomes
anticipated, and higher nominal wages adjustments are built in, so there is
only excess inflation, with no decrease in unemployment. This is known as
the inflation bias, and a large literature has developed on it, which explores
the structure of institutions, such as independence of a CB or appointment
of a conservative central banker that can allow the CB to resist potential
pressure. Bureaucrats are expected to be able to take a longer view
compared to politicians since their reputation is their prime objective, not
winning elections.
But in a poor populous democracy without full indexation of wages
and prices, inflation hurts the poor who have the most votes. Therefore,
democratic accountability also acts to force the CB to keep inflation low,
not high as in mature economies. It is the fiscal authority that is tempted
into excess populist expenditures, forcing the CB to accommodate fiscal
needs, while using distorting administrative measures, including credit
controls, to keep inflation low.
A democratically accountable Central Banker in a developing
democracy would anyway keep inflation low, so if stricter rules restrain
fiscal populism the CB can focus less on inflation and more on growth.
More autonomy to the CB can, without changes in the rules of the game
through fiscal reform, lead to higher interest rates that increase the burden
of public debt and have a high output cost. CBs are accountable if they are
partially independent. Too much independence can reduce democratic
accountability. One way to prevent this is to allow instrument but not goal
independence. The government sets the social goal but the CB is free to
implement it using its professional competence and knowledge (Goyal 2002,
2007).
1 Precedents and Path Dependence
Pre independence the discussion preceding the setting up of the
RBI emphasized the importance of setting up an institution free of political
26 History of Monetary Policy in India
influence
12
. There was a debate, but even those on opposite sides agreed
on the importance of at least instrument independence. Under the pre-
Independence RBI Act it was obligated to carry out the responsibilities laid
on it by Statute. It was nationalised at Independence, but under the
constitution and the division of responsibilities, if the RBI said no to the
finance minister, the government would have to go to Parliament, which
could assert some discipline.
But the early view of planning as a national goal established
precedents and procedures that vitiated the autonomy of the RBI. The
initial jockeying between the RBI and the Ministry of Finance
13
made it
clear the RBI was to be regarded as a department of the government.
Monetary policy was another instrument to achieve national goals. The
RBI lost even instrument independence.
“For the Reserve Bank of India therefore, short-term monetary
policy meant not merely managing clearly identified variables such as the
price level or the exchange rate, but doing so consistent with supporting a
given Plan effort. …The practical necessities of decision making under
multiple constraints often led to the adoption, sometimes against the better
judgment of its officers if not always of the Bank, of measures which
created bigger problems in the longer-term than the more immediate ones
they helped resolve. As the logic of decision-making became endogenised
in the form of precedents and institutional evolution, the course was set for
departures which however small or partial in the beginning, exercised over
a period of time a tangible influence on the overall effectiveness of the
Bank’s monetary policy (Balachandran 1998, p 10)”
An example of such a precedent was the RBI’s agreement to the
Government’s January 1955 proposal to create ad hoc treasury bills to
maintain the Government’s cash balances at 50 crores or above, thus making
soft credit available to the government in unlimited quantities. With the aid
of this facility, the issue of ad hocs rose during the second plan. The
Government also reduced safeguards restricting currency expansion.
12
The cynics view was this was to ensure the country remained solvent and could
continue to make payments to the British (see Anjaneyulu et al 2010).
13
In the mid-fifties Rama Rau, the then governor of the RBI resigned because of
pressures from the Finance Minister TT Krishnamachari. The latter imposed a
steep rise in the stamp duty of bills that effectively destroyed the bill market that
Rama Rau was keen to develop.
Institutions 27
The RBI’s early conservative CB stance changed by the second
Plan to one that supported the Government’s financing requirements. By
1967 the heterodox 1951 Yojana Bhavan perspective on monetary policy
had become the orthodox RBI view—it had adopted and internalised the
opposite government view. Where the Government pulled the RBI found
itself following.
The government wanted lower interest rates given its large
borrowings, and this made it difficult for the RBI to raise rates
14
. The RBI
early showed itself to be susceptible to pressures to support government
borrowing through the Gsecs. Even in 1951 banks were given an exemption
from showing capital losses from their holdings of Gsecs on their balance
sheets (Balachandran 1998, pp. 55). As manager of the government debt
the RBI generally sought to support the government borrowing programme.
Independence depended also on personalities. Governor
Bhattacharyya raised the Bank Rate over 1963-65, for the first time after
1957. In the early ’fifties, under Rama Rau, the Bank Rate was changed,
and there were attempts to develop an active bill market for short-term
financing. In the 1920s and 1930s an active bill market had provided seasonal
finance.
In 1962, Iengar pointed out four areas of conflict between the
Government and the RBI: interest rate policy, deficit financing, cooperative
credit policies and management of sub-standard banks. The RBI had worked
towards larger sized financially viable rural cooperatives that would have
eliminated the middleman. But the government destroyed these initiatives
by insisting on village level cooperatives and on using rural credit as
patronage. There were dissenting voices to the path the country and its
institutions were taking (Chandavarkar 2005). An article in the Hindu
commenting on an early RBI committee pointed to the dangers of
entrenching State control and distrust of the individual (Balachandran 1998,
pp. 241). It was feared the government’s top down approach towards the
cooperative movement would reduce self-reliance and increase dependence
on the State.
14
In 1964-65 Finance Minister TT Krishnamachari even claimed for the Government
the right to announce Bank rate changes when Parliament was in session. But
Bhattacharyya was able to defend the Bank’s right to announce the Bank Rate,
and was also able to raise rates. Even such “symbolic” rights are important for
autonomy (pp. 741 Balachandran, 1998).
28 History of Monetary Policy in India
In 1967, Governor Jha stated that given the plans, it was not possible
to control aggregate credit. So the RBI should focus on controlling sectoral
credit to achieve its twin goals of development and stability (Balachandran
1998, pp. 730). Worried about the effect of steady monetization of deficits
on the money supply, the Bank fought for and got additional powers in
1956, by expanding Section 42 of the RBI Act, to give it control over banks’
cash reserves. A 1962 modification gave it the power to vary the CRR
between 3 and 15 per cent of scheduled bank’s demand and time liabilities.
The liquidity provisions of the Banking Companies Act were also changed
and termed the Statutory Liquidity Ratio (SLR). It was now possible to use
these to divert bank resources for government financing, while reducing
money supply.
The economy had always been vulnerable to the monsoon. In the
early seventies oil shocks were a new kind of supply shock. The Government
and the RBI were afraid of high inflation. The new instruments enabled a
squeeze on money and credit in response to supply shocks, which intensified
the demand recession that followed. This discouraged growth and
productivity increases that would have lowered inflation from the cost side.
The stagnation in the economy, rising government indebtedness,
and scarcity of foreign exchange precipitated a balance of payment crisis
in the early nineties. More openness was regarded as a solution. This was
the way the rest of the world was going and was also in line with current
dominant global ideas. But more openness required more credible institutions.
Poor fiscal finances had precipitated many outflows and currency crises in
emerging markets. Therefore liberalising reforms in the ’nineties
strengthened the autonomy of the RBI compared to the Government. Ad-
hoc treasury bills and automatic monetisation of the deficits was stopped in
the ’90s. The Ways and Means Advance (WMA) system was started in
1997. Primary issues of government securities no longer devolved on the
RBI. From April 1, 2006, the RBI no longer participated in the primary
auction of government securities.
2 Strengthening Institutions
A Fiscal Responsibility and Budget Management (FRBM) Act was
enacted by Parliament in 2003. The Rules accompanying the FRBM Act
required the Centre to reduce the fiscal deficit to 3 per cent of GDP and,
eliminate revenue deficit by March 31, 2008. The budget was to each year
place before Parliament the Medium Term Fiscal Policy, Fiscal Policy
Strategy and Macroeconomic Framework statements. Monetization of the
Institutions 29
deficit was banned, but there were no restrictions on OMOs. Any deviations
from the FRBM Act require the permission of Parliament. If the targets
were not met, a pro-rata cut on all expenditures was to be imposed without
protecting capital expenditure. There is also a ceiling on guarantees. But
the ceilings were allowed to be exceeded during “national security or national
calamity or such other exceptional grounds as the Central Government
may specify”, so that the Government could legislate itself out of the
commitments. As it did after the Lehman crisis when it deviated from the
mandated consolidation path, requesting the 13
th
Finance Commission to
set out a new path.
The FRBM Act brought down only reported deficits. The global
crisis exposed the inadequate attention paid to incentives and escape clauses
in formulating the Act. Loopholes were found to maintain the letter of the
law even while violating its spirit. Off-budget liabilities such as oil bonds
were used to subsidise some petroleum products. Targets were
mechanically achieved, compressing essential expenditure on infrastructure,
health and education, while maintaining populist subsidies. The Act requires
to be reframed to improve incentives for compliance. Expenditure caps
that bite especially on transfers, while protecting productive expenditure,
will create automatic counter-cyclical stabilisation as tax revenue falls and
deficits rise in a slowdown. They will also moderate the temptation to raise
expenditure when actual or potential revenues rise. These are an example
of automatic non-discretionary stabilizers. With phased caps on spending
rather than on the deficit, the latter could increase in case of economic
slowdown when revenues fall, thus allowing automatic macro-stabilisation,
and increasing the political feasibility of the scheme. The deficit should be
allowed to vary over the cycle, that is, it should be cyclically adjusted.
In the Indian context, especially urgent are detailed expenditure
targets for individual ministries, and levels of government, as part of improved
accounting, including shifts from cash to accrual based accounts. These
should change the composition of government expenditure towards
productive expenditure that improves human, social, and physical capital,
and therefore the supply response. Essential transfers must be better targeted
to reduce waste, and the effectiveness of government expenditure improved.
Any permanent rise in expenditure must be linked to a specific tax source.
The 13th Finance Commission brought in some cyclical adjustment but did
not built in better incentives for compliance.
A more credible FRBM will allow better fiscal-monetary
coordination. To use Woodford’s (2003) terminology, an active monetary
policy can support growth if fiscal policy passively follows the path of
30 History of Monetary Policy in India
consolidation. They can then switch positions during a crisis with monetary
policy passively supporting active fiscal stimuli. The more usual combination
in post-reform India, as the RBI gained greater independence, was for both
to be active, which harmed growth, as overall monetary tightening sought
to compensate for fiscal giveaways. Sharp rise in policy and other liberalised
interest rates lowered growth after the reforms. When Indian interest rates
did fall after 2000, despite high government deficits, and aggressive
sterilisation, because international interest rates fell, growth was stimulated.
If fiscal legislation successfully shifts the composition of public
expenditure, then openness gives an opportunity for monetary authorities to
lower Indian real interest rates closer to world levels. Since accountability,
in a democratic policy, forces the CB to keep inflation low, a weak constraint
on the CB – such as medium-term inflation zone targeting – would be
credible. This stabilises inflation expectations, so that the cost of dis-inflation
is lower. Thus, measures to change aggregate demand would be required
only if inflation forecasts are outside the zone; otherwise productivity
improvements can be allowed to decrease inflation in their own time, under
expanding potential output. This gives sufficient discretion to smooth nominal
interest rates and achieve the desired real interest rates (Goyal 2002).
3 Openness, Markets and CB Autonomy
Threats to the autonomy of CBs come not only from the
Government, but also from free capital flows. The Mundell-Fleming model
tells us that with perfect capital mobility, static expectations, and a fixed
exchange rate monetary autonomy is lost. Monetary policymakers often
refer to this impossible trinity, indicating their helplessness before waves of
foreign inflows, and the increasing dominance of the market. But
internationally, and in India, the potential impact of monetary policy has
increased with the reforms. First, exchange rate regimes in most countries,
and especially in EMs like India, are somewhere between a perfect fix and
a perfect float. Even partial flexibility of exchange rates gives some monetary
autonomy. Second, the absence of complete capital account convertibility
(as in India) opens up more degrees of freedom. Consider a triangle where
the bottom two corners represent a fixed and a floating exchange rate and
the line between them depicts the whole range of intermediate regimes.
The upper point is a closed capital account, so that in approaching the
bottom line convertibility gradually increases until perfect capital mobility is
reached on the line. Therefore, the impossible trinity is only one point of the
triangle. Everywhere else there is varying degrees of monetary autonomy.
Institutions 31
So, in the net, more openness increased degrees of freedom for policy. The
loss in freedom from capital flows was not large enough to nullify the freedom
from deficit financing.
Deeper markets with greater interest sensitivity make monetary
policy more effective. To the extent behaviour is forward-looking, taking
markets into confidence, or strategic revelation of information, can
sometimes help achieve policy objectives. But markets factor in news and
the expected policy stance making it difficult for policy to go against market
expectations. So, in a sense, monetary policy also looses autonomy to free
markets. The latter demand transparency, and like predictability. But after
the Global Financial Crisis it is recognised that price discovery in markets
can deviate from fundamentals. Market efficiency does not always hold
and markets do not satisfy rational expectations.
Markets can get caught in a trap of self-fulfilling expectations
around unsustainable overleveraged positions. So it is necessary at times to
focus expectations around better outcomes. This may involve surprising
markets—creating news. Blinder et al (2008) show that the two ways in
which communication makes monetary policy more effective is by creating
news or reducing uncertainty. Surprise can be compatible with more
transparency if it is linked to random shocks to which the system is subject—
then communication enhances news (Goyal et al 2009). Thus free markets
also reduce CB autonomy but the global crisis has resulted in giving institutions
and regulators some degrees of freedom. It has also led to a re-assessment
of the CB’s objective beyond a narrow focus on inflation targeting. Financial
stability has been recognized as a major objective. As the regulator of banks,
the RBI has always given priority to financial stability, and has effectively
used macro-prudential instruments. These are now being recognised
worldwide as necessary complements to the interest rate instrument.
4 Bank Governors and Delegation in India
One of the measures suggested in the literature to increase
independence is to delegate authority to a conservative central banker, who
will then impose own preferences on the growth inflation trade-off
(Vasudevan 2007).
32 History of Monetary Policy in India
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Institutions 33
Table 7 shows growth, inflation and monetary policy have differed
in the tenures of various Reserve Bank governors. The overall direction
may have been dictated by the preferences of the elected government,
given lack of constitutional autonomy. But the delegated agent, or the
Governor, has been able to make a difference. The divergence in performance
in the regimes of different governors suggests that their preferences
affected growth rates. Second, governors in whose regime growth was
higher have delivered lower inflation, since cost shocks normally sparked
higher inflation, but the monetary response affected growth and future
inflation. Short-run sharp inflation caused by supply shocks was controlled
through a fall in demand, but it harmed longer-term growth. The clear
differences in regimes suggest that governors whose policies discouraged
recovery in growth ended up with higher inflation also (Goyal 2007). The
two governors with the highest rates of growth of reserve money, Dr
Manmohan Singh and Dr Y V Reddy, also had local maxima in rates of
growth and minima in rates of inflation.
V. OUTCOMES
Early monetary policy was geared to support planned expenditures
and government deficits
15
. During an agricultural shock monetary policy
would initially support increased drought relief then tighten just as the lagged
demand effects of an agricultural slowdown were hitting industry.
Administered oil and food prices were normally raised with a lag after
monetary lightening brought inflation rates down. Macro policy was thus
pro-cyclical, but pervasive controls limited volatility.
1 The Historical Trajectory
Severe drought and terms of trade shocks over 1965-67, led to a
fiscal tightening, with a cut in deficits and in public investment. Monetary
policy following a credit targeting approach was non-accommodating but
not severe. Fiscal-monetary policies were closely linked, as the budget
deficit was automatically financed. Severe monetary and fiscal measures
followed the oil price plus agricultural supply shock over 1973-75. In both
cases there was an unnecessary loss of output. A focus on expanding supply
would have been more effective. After the 1979-80 oil shock, a cut in
public investment and sharp monetary tightening was avoided. Recovery
was rapid, but deficits and supply side inadequacies continued.
The relatively closed, import substitution and public investment driven
model of development followed, allowed macro-policy to be geared towards
domestic requirements. As growth slowed, successful lobbying for subsidies
could have led to increasing reliance on seignorage, since inflation is an
easy-to-collect tax. But where more than half the population was below
the poverty line and an even larger percentage had no social security or
other protection against inflation, governments concerned with re-election
could not afford high inflation. Thus, even though there was some positive
seignorage revenue and automatic monetisation of the deficit, commercial
banks’ ability to multiply the reserve base and create broad money was
partially countered through draconian compulsory reserve and statutory
liquidity requirements. This, together with administered prices, restrained
inflation to politically-acceptable levels. Thus, political business cycles in
India largely took the form of a cut in long-term development expenditures
and interventions that distorted allocative efficiency, not of increased money
15
The analysis in this section draws on RBI publications including monetary
policy statements, speeches by RBI governors and data available on the RBI’s
website www.rbi.org.in and my earlier publications.
Outcomes 35
creation. The future was sacrificed to satisfy populism in the present (Goyal
1999).
Since the seventies, dominant development ideas changed to favour
openness. In India also the ill effects of controls were becoming obvious.
Some liberalisation started in the mid-eighties, but a major thrust for external
openness came from the mid 1991 balance of payment crisis when foreign
exchange reserves were down to 11 days of imports. The crisis helped
bring home the lesson that excessive interest controls and credit rationing
were deleterious to growth and stability (Thorat 2010). It made possible the
implementation of the series of pending committee reports.
Current account and partial capital account liberalisation, and a
gradual move to more flexible exchange rates followed. Sequencing was
well thought out. While controls continued on domestic portfolios and debt
inflows, equity inflows were liberalized. Equity shares risks, while short-
term debt flows create a heavy repayment burden in adverse times. On
foreign debt, the sequence of relaxation favoured commercial credit and
longer term debt (Rangarajan 2002, 2004). Major reforms were undertaken
towards development of equity, forex money and government securities
markets. Although low by developing country standards, Indian inflation
was higher than world rates. Accumulation of large public debt made the
fiscal-monetary combination followed in the past unsustainable. The
automatic monetisation of the government deficit was stopped and auction
based market borrowing adopted for meeting the fiscal deficits. The
repressed financial regime was dismantled, interest rates became more
market determined and the government began to borrow at market rates.
Bank liquidity funded speculative buying through repurchase
transactions in government securities and bonds. These stock market scams
led to further action to remove weaknesses such as lack of transparency in
the market infrastructure for government securities, excess liquidity with
public sector undertakings, inadequate internal controls due to low levels of
computerization and reliance on manual processing, which made the nexus
between banks and brokers feasible. All administered interest rates were
deregulated except the savings bank deposit rate. RBI initiated a delivery
versus payment mechanism for settlement of trades in government securities
was, leading to establishment of the CCIL (Clearing Corporation of India),
a central counterparty to undertake guaranteed settlement for government
securities, repos in Gsecs and forex market trades.
36 History of Monetary Policy in India
As the bank regulator, RBI was an early pioneer in countercyclical
prudential regulations that are being adopted worldwide after the global
financial crisis. Provisioning for bank housing and commercial real estate
loans was raised as a countercyclical measure when Indian real estate
prices rose after 2005. Accounting standards did not permit recognition of
unrealized gains in equity or the profit and loss account, but unrealized
losses had to be accounted. The relative conservativeness, without full
marking-to-market requirements, reduced pro-cyclical incentives. Banks
were required to mark-to-market only investments held in trading categories.
Exposures had conservative capital adequacy requirements under 2006
guidelines on securitization. Any profits on sale of assets to a special purpose
vehicle were to be recognized only over the life of the pass through
certificates issued, not immediately on sale (Goyal 2009). These types of
prudential regulations affect behaviour while minimizing high transaction
costs imposed by discretionary credit controls. They give a powerful
additional weapon to prevent asset price bubbles, allowing the policy rate to
focus on the real sector. In a more complex economy, credit controls become
difficult for the regulator to operate, apart from the distortions they cause.
By 1994 selective credit control operations had been largely phased out.
The basic objectives of monetary policy remained price stability
and development, but in line with the recommendations of the Chakravarty
Committee (RBI 1985), the operating procedures had shifted from credit
controls towards flexible monetary targeting with ‘feedback’ from the mid
1980s till 1997-98. But deregulation and liberalization of the financial markets
combined with the increasing openness of the economy in 1990s made
money demand more unstable, and money supply more endogenous. The
RBI itself noted monetary policy based on demand function of money, in
these circumstances, was expected to lack precision (Reddy 2002).
The informal nominal money supply targeting proved inadequate under
these changes; interest rates were volatile in the 1990s. After the adverse
impact of the nineties peak in interest rates, the Reserve Bank moved
towards using the interest rate as an instrument, basing its actions on a
number of indicators of monetary conditions (Jalan 2001). It formally adopted
a ‘multiple indicator approach’ in April 1998, following informal changes in
practice from the mid nineties
16
. There was no formal inflation targeting,
but policy statements gave both inflation control and facilitating growth as
key objectives. A specific value of 5 per cent was given as the desirable
rate of inflation, with the aim to bring it even lower in the long-term. The
aim was to reduce reliance on reserve requirements, particularly the Cash
Outcomes 37
Reserve Ratio (CRR), shifting liquidity management towards OMOs in the
form of outright purchases/sales of Gsecs and repo and reverse repo
operations. Table 8 summarises these changes.
Table 8: Monetary Policy Procedures
Monetary Policy 1950s to Early 1990s to 1998-99 to
End 1980s 1998-99 Present
Objectives 1) Stability 1) Inflation 1) Inflation
2) Development 2) Credit supply for 2) Growth
growth
Intermediate Priority sector credit Monetary targeting Multiple indicator
target targeting with annual growth approach (namely
in broad money (M
3
) money, capital,
as intermediate currency,
target external etc.) as
intermediate target
Operating Direct instruments Gradual interest rate Direct (CRR, SLR)
procedure (interest rate deregulation CMR; and indirect
(Instruments) regulations, Direct instruments instruments (repo
selective credit (selective credit operations under
control, SLR , CRR) control, SLR, CRR) LAF and OMOs)
2 Excess Demand or Cost Shocks?
The official understanding of monetary policy in India is that huge
monetary overhang built up due to financing of large fiscal deficits created
excess demand that had to be sharply reduced during periods of high inflation.
But Mohanty (2010) in his Table 2 shows that every period of double-digit
inflation in India was associated with a supply shock.
16
A vector autoregression model following Christiano et al (1999) showed the
growth of reserve money better indicates the stance of monetary policy for 1985
M1 to 1995 M12 and call money rate for 1996M1 to 2005M3. This supports the
changing operating procedure of monetary policy in India from quantity to rate
variables. The results of forecast error variance decomposition for the later sub
period show shocks to exchange rate to be important in explaining unexplained
variance of inflation, movements of credit and money supply growth. These
findings highlighted the growing importance of the exchange rate channel. While
agricultural shocks were the main driving factor of domestic inflation from mid
80s to mid 90s, their explanatory power went down substantially post-reform.
International factors became the main drivers of Indian inflation (Agrawal 2008).
38 History of Monetary Policy in India
Chart 4 shows growth of reserve money (RM), broad money (M),
and real GDP since the ’fifties. Chart 5 shows WPI inflation. RM shows
large fluctuations from the seventies, demonstrating the limited control left
with the RBI. The fluctuations reduce in the 90s after the removal of
automatic monetisation. But large inflows push it up again in the 2000s.
The fluctuations in broad money are much lower, however, demonstrating
the greater control the RBI exerted through use of the CRR and SLR. The
early large fluctuations in output growth and inflation both occur during
period of supply shocks, and both are moderated from the mid-nineties.
Table 9: Policy and Outcomes in High Inflation and other Years
Years Demand Demand Policy Credit Real WPI
Shock Shock Shock Shock GDP Inflation
without Growth
CAD
Average Annual Growth Rate
1953-56 0.5 0.6 1.4 4.2 4.7 -3.3
1956-57 -1.8 0.6 -2.2 -7.5 5.6 14.0
1957-64 -0.8 -0.9 0.6 0.4 4.0 3.9
1964-65 1.0 1.3 -0.3 -3.4 7.5 11.0
1965-66 2.2 2.2 1.4 3.3 -2.7 7.6
1966-67 2.1 3.0 -1.5 -0.5 0.0 13.9
1967-72 -0.4 -0.8 0.2 3.0 4.9 5.0
1972-75 0.4 0.5 -0.8 0.5 1.3 18.5
1975-79 0.8 0.5 1.8 6.5 6.0 1.6
1979-81 -0.9 -0.3 -0.2 4.8 0.8 17.7
1981-90 -0.3 -0.2 0.7 3.0 5.6 6.8
1990-92 -0.9 -1.9 -1.4 -1.8 3.3 12.0
1992-94 -0.7 -0.6 0.1 -0.9 5.1 9.2
1994-95 1.1 1.7 0.1 3.2 6.7 12.6
1995-08 0.4 0.4 0.1 5.6 7.0 5.1
2008-09 (QE) -0.9 0.2 0.4 13.5 6.8 8.3
Note: Figure in bold indicate the years in which inflation was in double digits.
CAD- Current Account Deficit; WPI- Wholesale Price Index; GDP- Gross
Domestic Price
Table 9 helps to further understand these charts. It captures the
monetary and fiscal response to supply shocks in the “Policy” variable.
Measuring the policy response to an exogenous shock helps to cut through
the endogeneity plaguing macroeconomic systems. The policy reaction
responds to the shocks and affects the outcomes in such episodes. The
policy shock is calculated as the rate of change of reserve money, Central
Outcomes 39
Government revenue, and capital expenditure each as a percentage of GDP.
That is, period t gives the total of the three variables each minus their
respective values in period t-1. This is then averaged to get per annum
rates for periods of double digit inflation (each associated with a supply
shock) and others. A negative value implies policy contraction exceeding
that in GDP. The table shows this to be negative in years when the GDP
growth rate fell due to an external shock. Thus policy amplified shocks.
The “credit” variable does a similar calculation for broad money
M3, bank credit to the commercial sector and total bank credit, capturing
outcomes of policy tightening. This was more severe in the earlier shocks.
The availability of more financial substitutes and of external finance reduced
the impact of policy tightening on credit variables. In the later years policy
was acting more through prices (interest rate changes) than quantities.
Finally the “demand” variable is the sum of changes in private final
consumption expenditure (PFCE), government expenditure (G), Gross
Domestic Capital Formation (GDCF), and current account deficit (CAD)
as a percentage of GDP. It is also given without CAD
17
egative impulse to
40 History of Monetary Policy in India
aggregate demand. While the supply shock pushed up the AS of section III,
the policy response shifted the AD leftwards. Demand remained positive
through the first oil shock years but fell steeply in 1975-76. It was
consistently negative through the eighties, the years of largest fiscal deficits
and RBI accommodation when the so-called “monetary overhang” was
developed. But there was no excess demand! Since the table measures
final demand categories, this suggests the large government transfers made
for the poor were being siphoned away, perhaps abroad, without reaching
beneficiaries
18
. Policy shocks were no longer negative after the mid-nineties,
helping explain the better performance. They were actually countercyclical
19
and positive during the global financial crisis.
Thus for much of the period, policy contraction exceeded that in
GDP in years when the GDP growth rate fell due to an external shock,
imparting a considerable negative impulse to aggregate demand.
3 Openness, Inflows and Policy
The other major change with greater openness was the higher
level of foreign inflows. Even gradual and sequenced capital account
convertibility led to large inflows of foreign portfolio investment (FPI). The
RBI’s acquisition of foreign assets was now driving reserve money growth
as RBI credit to the Government contracted. Reserves of foreign currency
accumulated, and were sterilised by a contraction of RBI credit to the
government, and through OMOs. The latter became possible by the mid-
17
A large CAD implies domestic resources are less than domestic requirements,
but it is a consequence of domestic demand, rather than an additional demand
component. A CAD implies domestic demand is leaking abroad. Including it
reduces demand even more as it widens during downswings in India. Goyal
(2011b) does a similar analysis for the individual years of external shocks.
18
GFI (Global Financial Integrity) (2010) estimates that tax evasion, crime, and
corruption have removed gross illicit assets from India worth US $462 billion
since independence.
19
Dash and Goyal (2000) found monetary policy broadly succeeded in preventing an
explosive growth in money supply and reined in inflationary expectations. But by
targeting manufacturing prices it harmed real output. Their estimations implied it
would be more efficient to target agricultural prices for inflation control. A monetary
contraction should be completed earlier than in the past, and should coincide with a
rise in food prices. Information available in the systematic structural features was
not exploited in designing monetary policy. Reserve Bank monetary control had
intensified shocks to real output, while being unable to prevent the expansion of
credit in response to a speculative profit motive.
Outcomes 41
1990s because of the financial liberalisation of the previous decade; the
debt market was deepening and government debt could be traded at market-
determined rates. But OMOs remained minor for fear of their impact on
the cost of government borrowing. The market was expected to discipline
government borrowing but as real interest rates rose and growth rates
fluctuated, government debt burden increased.
The CRR ratios that were being brought down in line with the
committee recommendations had to be raised again in a burden sharing
arrangement whereby the costs of sterilisation were to be shared by the
government, RBI and banks. Tables 10, 11 show the changes in India’s
openness across the decades. Reserves
20
as a ratio of GDP went from a
low of 1.35 in the early years to a high of 14.84. Exports plus imports
jumped from a stagnant 8-11 per cent of GDP in the first 40 years after
independence to 25 per cent. The dependence on oil imports increased.
While the current account of the balance of payments remained negative,
the capital account jumped to about 3 per cent of GDP. Exchange rate
depreciation was particularly large in the first reform decade.
Table 10: Average Annual Growth Rates
Reserves Exports Import Growth Growth of Exchange
(f.o.b) (c.i.f) of Oil Non Oil Rate
Imports Imports Depreciation
/Appreciation
1951-52 to 1959-60 -9.13 0.36 7.17 - - 0
1960-61 to 1969-70 10.79 8.87 6.63 - - 5.15
1970-71 to 1979-80 25.26 16.76 20.88 53.47 19.17 0.898
1980-81 to 1989-90 1.79 16.62 15.67 12.14 16.45 7.26
1990-91 to 1999-00 43.12 19.46 20.01 24.48 17.91 10.59
2000-01 to 2009-10 23.35 18.53 20.17 23.56 22.44 1.32
Post-reform macro-stabilisation included a cut in public investment,
monetary tightening partly to sterilise capital inflows and an artificial
agricultural supply shock as procurement prices for food grains were raised.
A benchmark real effective exchange rate was set after two-stage
20
FX reserves rose to over 300 billion US dollars in 2011, compared to a paltry 5
billion in 1990-91. 30 billion dollars were accumulated in just 18 months over
January 2002 to August 2003. Other years of large inflows were 2007 and 2010.
Outflows occurred after the global crisis in 2008, but were soon reversed. Arbi-
trage occurred at the short end since Indian short real rates were kept higher
than US rates.
42 History of Monetary Policy in India
devaluation in the early’ nineties, in order to maintain a competitive real
exchange rate and encourage exports to aid absorption of excess labour. It
was largely maintained. The nominal rate was kept stable for long periods
of time, and reserves accumulated under inflows. Growth revived in 1993-
94, and monetary policy was accommodating, but exchange rate volatility
in 1995 led to a monetary squeeze that precipitated a slowdown. The
monetary stance was relaxed, but reversed again at the first sign of exchange
rate volatility. Periodic bursts of volatility, sometimes induced by fluctuations
in foreign capital inflows, for example from mid-May to early August 2000,
were suppressed. But the sharp jump in interest rates triggered an industrial
recession and sustained it over 1997-2001. Goyal (2005) shows in this
slowdown period, foreign financial inflows measured as the surplus on the
capital account rose, but their volatility fell. The volatility of the CAD,
however, rose, suggesting it was policy that was creating volatility in the
absorption of inflows. The CAD, which is the difference between investment
and domestic savings, is affected by general macroeconomic policy.
Table 11: Ratio to GDP Market Price (percentage)
Reserves Exports Import Current Capital Oil Non Oil
(f.o.b) (c.i.f) Account Account Imports Imports
1951-52 to 1959-60 6.56 5.13 6.79 -0.81 0.27 - -
1960-61 to 1969-70 1.35 3.11 5 -1.61 1.57 - -
1970-71 to 1979-80 2.3 3.76 4.61 -0.1 0.59 1.31 4.09
1980-81 to 1989-90 2.45 4.02 6.84 -1.43 1.23 2.01 5.14
1990-91 to 1999-00 4.75 6.72 9.07 -1.22 1.98 2.11 7.11
2000-01 to 2009-10 14.84 10.3 14.57 -0.32 2.85 4.92 1.73
Although the exchange rate was said to be market determined,
massive RBI intervention continued in order to absorb foreign portfolio
inflows. Trend depreciation was facilitated through the nineties to cover
the inflation differential. There was some appreciation due to the weakening
of the dollar from 2002 and from 2004 there was mild two-way movement
of the nominal exchange rate (Chart 6). Foreign exchange reserves
accelerated in this period. The nominal exchange rate was now a managed
float. There was occasional excess volatility, but a crisis was avoided. Even
contagion from the East Asian crisis was averted. Some agricultural
liberalisation and falling world food prices did reduce the political pressures
that had raised food support prices and inflation, but exchange rate policy
was not systematically used to moderate the effect of the typical EM supply
shocks: oil price shocks and failure of rains.
Outcomes 43
Growth rates, moreover, were lower than potential. Monetary
tightening in the presence of supply shocks sustained the slowdown. Steady
softening of nominal interest rates occurred only after February 2001, as
world interest rates fell. A new RBI Governor, Bimal Jalan, demonstrated,
through staggered placement of government debt, that it was possible for
interest rates to come down despite high fiscal deficits and committed to a
soft interest rate regime even while preventing excess volatility of the rupee.
So there were reversals during periods of exchange rate volatility. In 1998-
99 the decision not to tighten monetary policy when inflation peaked with
certain food prices turned out to be correct as inflation fell. Similarly, inflation
fell again as the oil shock wore out, without a sharp tightening in monetary
policy, both in 2000-01, and in early 2003-04.
Sharp defensive rise in interest rates after shocks were, however,
implemented given policy makers’ perception that interest elasticities were
low
21
. Interest rates had been only recently freed; the impact of reforms on
21
Monetary policy shocks were identified using a short-run vector autoregression
model. The identification assumption on contemporaneous causality used to
isolate the policy shocks was exogenous shocks (foreign oil price inflation and
interest rates), and domestic variables (inflation, IIP growth and exchange rate
changes) affect the policy instrument variable (call money rates, or treasury bill
rates) contemporaneously, but the policy variables affect them only with a lag.
All these variables go on to affect gross bank credit and the broad monetary
aggregate (M). Domestic variables do not enter the lag structure of the foreign
variables since the Indian economy is too small to affect international prices.
The RBI’s reaction function or feedback rule to changes in the foreign shocks
and non-policy variables determines the setting of the policy instrument variable.
The policy shock is the residual from this estimated “reaction” of the RBI. It is
orthogonal to the variables in the RBI’s feedback rule. The residuals of the
‘monetary policy instrument’ equation give an estimate of the large monetary
policy shocks in this period (Goyal 2008b).
44 History of Monetary Policy in India
elasticities, in particular the impact of the interest rate on consumer spending,
was not yet fully understood. In addition, political pressures made the weight
given to inflation in the loss function high. The RBI had greater autonomy
after the reforms, but was not fully independent. The fiscal deficit was
thought to be large. There were doubts about the durability of capital inflows
and fears of a possible reversal, which would have implied a shock to the
risk premium. There was a perception that markets create excess volatility.
Finally, risk aversion explained the use of the interest rate defense.
Inflation fell in the late’ nineties, with the improvements in
productivity, and the influence of low global inflation in a more open economy,
but industrial growth did not revive until 2003, when Indian interest rates
followed falling global rates and public expenditure on infrastructure rose.
The lowering occurred not from a conscious policy decision but because
international interest rates were falling. Even with higher growth and an
extended period of high global oil prices, inflation remained low.
4 Money Markets and Interest Rates
Throughout this period, gradual financial reforms deepened markets.
As most interest rates stopped being administered, it became a more
effective policy instrument. The liquidity adjustment facility (LAF)
implemented around that time helped fine-tune domestic liquidity and short-
term interest rates drifted downwards. The absence of a reversal since
2000, contributed to an upswing in activity, as benign markets expectations
strengthened. Bursts of high volatility in exchange rates were absent during
this period. FX markets had the highest growth rates in the world. The
fiscal deficit fell after a long time, with higher growth and lower interest
rates, when the opposite policy of periodic rise in interest rates had not
succeeded over 1997-02.
The repo and reverse repo rates began to be changed frequently
and smoothly, and the call money rate largely stayed within the band
determined by them. Charts 7 to 11 show the changes in the interest rate
regime, the increasing sophistication of markets, and market determination
of rates. The RBI’s general refinance rate, the Bank Rate, peaked in the
early nineties and fell after that, but was not changed very frequently (Chart
7). Volatility in the call money rate (CMR) was much lower after the mid-
nineties. Although liberalisation initially increased the volatility of rates in a
thin market, it eventually brought down the volatility to levels prevailing
when rates were tightly administered, as markets deepened. But now rates
came through a complex market process (Chart 8).
Outcomes 45

0
2
4
6
8
10
12
14
1
5
-
1
1
-
1
9
5
1
1
6
-
0
5
-
1
9
5
7
3
/
1
/
1
9
6
3
2
6
-
0
9
-
1
9
6
4
1
7
-
0
2
-
1
9
6
5
2
/
3
/
1
9
6
8
9
/
1
/
1
9
7
1
3
1
-
0
5
-
1
9
7
3
2
3
-
0
7
-
1
9
7
4
1
2
/
7
/
1
9
8
1
4
/
7
/
1
9
9
1
9
/
1
0
/
1
9
9
1
1
6
-
0
4
-
1
9
9
7
2
6
-
0
6
-
1
9
9
7
2
2
-
1
0
-
1
9
9
7
1
7
-
0
1
-
1
9
9
8
1
9
-
0
3
-
1
9
9
8
3
/
4
/
1
9
9
8
2
9
-
0
4
-
1
9
9
8
2
/
3
/
1
9
9
9
2
/
4
/
2
0
0
0
2
2
-
0
7
-
2
0
0
0
1
7
-
0
2
-
2
0
0
1
2
/
3
/
2
0
0
1
2
3
-
1
0
-
2
0
0
1
3
0
-
1
0
-
2
0
0
2
3
0
-
0
4
-
2
0
0
3
Chart 7: Bank Rate

0
5
10
15
20
1
9
5
0


1
9
5
2


1
9
5
4


1
9
5
6


1
9
5
8


1
9
6
0


1
9
6
2


1
9
6
4


1
9
6
6


1
9
6
8


1
9
7
0


1
9
7
2


1
9
7
4


1
9
7
6


1
9
7
8


1
9
8
0


1
9
8
2


1
9
8
4


1
9
8
6


1
9
8
8


1
9
9
0


1
9
9
2


1
9
9
4


1
9
9
6


1
9
9
8


2
0
0
0


2
0
0
2


2
0
0
4


2
0
0
6


2
0
0
8


Chart 8: Call Money Rate

0
5
10
15
20
25
30
35
40
45
Chart 9: Annual Averages
CRR SLR
46 History of Monetary Policy in India
Chart 12: Transmission of RBI Repo Rates

1
4
7
10
13
1
/
1
/
2
0
0
4
4
/
1
/
2
0
0
4
7
/
1
/
2
0
0
4
1
0
/
1
/
2
0
0
4
1
/
1
/
2
0
0
5
4
/
1
/
2
0
0
5
7
/
1
/
2
0
0
5
1
0
/
1
/
2
0
0
5
1
/
1
/
2
0
0
6
4
/
1
/
2
0
0
6
7
/
1
/
2
0
0
6
1
0
/
1
/
2
0
0
6
1
/
1
/
2
0
0
7
4
/
1
/
2
0
0
7
7
/
1
/
2
0
0
7
1
0
/
1
/
2
0
0
7
Chart 10: Daily: 2004-07
Repo Reverse Repo CMR

1
3
5
7
9
11
13
15
1
/
1
/
2
0
0
8
3
/
1
/
2
0
0
8
5
/
1
/
2
0
0
8
7
/
1
/
2
0
0
8
9
/
1
/
2
0
0
8
1
1
/
1
/
2
0
0
8
1
/
1
/
2
0
0
9
3
/
1
/
2
0
0
9
5
/
1
/
2
0
0
9
7
/
1
/
2
0
0
9
9
/
1
/
2
0
0
9
1
1
/
1
/
2
0
0
9
1
/
1
/
2
0
1
0
3
/
1
/
2
0
1
0
5
/
1
/
2
0
1
0
7
/
1
/
2
0
1
0
9
/
1
/
2
0
1
0
Chart 11: Daily: 2008-10
Repo Reverse Repo CMR CBLO
3
5
7
9
11
13
15
Jan-08 Apr-08 Aug-08 Nov-08 Mar-09 Jun-09 Oct-09 Jan-10 May-10 Aug-10 Dec-10
MIBOR_1Y CD_1Y WHTD_1Y TBILL_1Y RBI Repo
Outcomes 47
Chart 9 shows the SLR and CRR rates peaking (at respectively
37.25 and 14.75) in the early ’nineties, and then coming down as the repressed
financial regime was dismantled. The RBI absorbed liquidity at the reverse
repo and injected it at the repo. Charts 10 and 11 show the bands created
by the repo and reverse repo rates as the LAF matured and was actively
used after 2004. By this time most of the sector refinance facilities had
been wound up. Chart 10 gives the daily CMR. This peaked briefly in 2007
when the RBI limited borrowing in the LAF to encourage the development
of the inter-bank market. The collateralised borrowing and lending market
was developed and these CBLO rates are also shown in Chart 11. Since
lending was based on collateral, market rates could be above the upper
band during periods of tight liquidity when collateralisable securities were
exhausted as in 2010-11. But for much of the period rates hugged the lower
band as the RBI used the LAF to absorb excess liquidity generated by
large foreign inflows. So the volatility of call money rates, although reduced,
was still appreciable since they could jump from one edge of the band to
the other.
Chart
22
12 shows how the short policy rates began to influence
longer maturity rates through the term structure, demonstrating one leg of
active monetary transmission through rates. Policy was working now with
both price and quantity variables. There were large autonomous changes in
liquidity due to forex inflows, variations in government cash balances held
with the RBI and banks behaviour. Continued use of CRR changes also
added to jumps in liquidity. The RBI was not able to forecast and fine-tune
liquidity sufficiently to keep the CMR in the middle of the band. This was
also insufficient appreciation that now policy had to act through the cost of
funds or a shifting of the band, rather than liquidity squeeze. The latter was
not compatible with keeping interest rates within the band.
Following the recommendations in RBI (2011) these issues were
sought to be addressed by making the repo rate the signal of the policy
stance with a marginal standing facility (MSF) at 100 basis points above
and absorption at 100 basis points below the repo rate. The MSF would
make liquidity available up to 1 per cent of the SLR. Steps were also taken
to improve liquidity forecasting and reduce transaction costs in accessing
liquidity from the RBI, so as to allow finer tuning of liquidity requirements
and smoother adjustment of market rates.
22
This chart was part of the background papers prepared for RBI (2011).
48 History of Monetary Policy in India
5 The Global Crisis, Response and Revelation of Structure
Inflation rose after the severe international food price and oil shocks
over 2007-08 prompted a steep monetary tightening despite slowing industrial
output. The global crisis worsened the crash in industrial output. International
credit froze, trade fell, domestic liquidity dried up due to outflows, and fear
stalled consumption and investment plans. The global push for concerted
macroeconomic stimulus allowed Indian macroeconomic policy, despite high
government debt, to be countercyclical for the first time. Fiscal stimulus
amounted to about 3 per cent of GDP. RBI made available potential primary
liquidity of about 7 per cent of GDP. Just after the crisis India was regarded
as a high-risk country with low fiscal capacity, but the rapid monetary-
fiscal response helped give it a V-shaped recovery with one of the highest
growth rates (6.7 per cent). The financial system remained sound. The
potential of countercyclical macroeconomic policy was demonstrated.
Shocks hitting the economy serve as useful experiments helping to
reveal its structure. Consider the summer of 2008. The economy was thought
to be overheating after a sustained period of over 9 per cent growth.
International food and oil spikes had contributed to high inflation. The sharp
monetary tightening raising short rates above 9 per cent in the summer of
2008, and the fall of Lehman in September, that froze exports, were large
demand shocks hitting the economy. Industrial output fell sharply in the last
quarter, but WPI-based inflation only fell with oil prices in the end of the
year, and CPI inflation remained high. Demand shocks with a near vertical
supply curve, should affect inflation more than output. But the reverse
happened. Output growth fell much more than inflation.
The V-shaped recovery, which set in by the summer of 2009, also
indicated a reduction in demand rather than a leftward shift of a vertical
supply curve. A destruction of capacity would be more intractable; recovery
would take longer. Since labour supply ultimately determines potential output
for the aggregate economy, the region has a large potential.
Such outcomes are possible only if inflation is supply determined,
but demand determines output. This is the precise sense in which the
economy is supply constrained. Components of demand such as consumer
durable spending, housing, etc. are interest sensitive. During the crisis, the
lag from policy rates to industry was only 2-3 quarters for a fall and one
quarter for a sharp rise. Policy rates have impacted output growth since
1996. Supply constraints affect inflation
23
.
23
Parts of these arguments have also been made in Goyal (2011a, 2012)
Outcomes 49
The crisis response was fast but the resurgence of inflation before
recovery was firmly established led to policy dilemmas regarding exit. The
sharp resurgence of WPI inflation by Q3 of 2009 was regarded as surprising
since industry had barely recovered. But it should have been expected
given the impact of sustained high CPI inflation on wages. Because of the
latter, the manufacturing price index fell only for a few months, and had
risen to its November 2008 value of 203 by April 2009. A booming economy
does add pricing power, but supply side shocks explain even manufacturing
inflation. Arguments that the economy was overheating were probably
incorrect because of the sharp rebound in investment after the four-quarter
slump, while growth in private consumption and bank credit remained low.
Growth in government consumption also slowed sharply as investment
recovered. But not enough was done to anchor inflationary expectations
and to reduce constraints in agricultural markets. A poor monsoon in 2009
and protracted rains in 2010 aggravated food price inflation. CPI inflation
finally began to fall with a bumper harvest in 2011.
The response to early signs of industrial inflation was delayed, given
the very large cut in interest rates that had to be reversed. The delay led to
too fast a pace of increase in interest rates
24
and to quantitative tightening.
The latter contributed to volatility in interest rates and in industrial output.
Government expenditure pumped into the informal sector increased demand
for food. Demand for currency actually increased and financial dis-
intermediation occurred. Financing for firms was coming from abroad as
domestic credit growth remained slow. Firming oil prices added to wage
pressures from food inflation and costs rose. Liquidity remained tight and
demand contracted. Growth in industrial production softened and that in
investment also fell sharply in Q1 of 2011. As elasticities increase and
systems become more complex, blunt instruments should be phased out,
and policies designed to reduce sharp changes.
If policy is better based on structure and shocks, it could more
successfully smooth cycles and maintain growth. The events bring out
frequent supply shocks and also show a large impact of demand on output,
and of supply shocks on inflation. As higher growth paths became well
established, the AD AS analysis of Section III becomes more applicable.
Although the longer-run aggregate supply is elastic given youthful populations
in transition to more productive occupations, it is subject to frequent negative
supply shocks (Figure 1).
24
The operative rate went from the reverse repo at 3.25 in March 2010 to the repo
at 7.5 by June 2011.
50 History of Monetary Policy in India
With a supply shock as a result of monsoon failure or international oil
price rise, the aggregate supply curve in the figure shifts upward and this
leads to higher inflation. If in response, a demand contraction shifts the
aggregate demand curve downward, this reduces inflation only marginally
and at a high cost in terms of output lost. Policy should instead restrict
demand just sufficiently to prevent inflationary wage and price expectations
shifting up the supply curve, while encouraging supply-side improvements
that can shift down the AS curve. The relative elasticities of AS and AD
curves suggest a rethink of the common argument that pricing power of
firms rises when demand is high. Firms tend to pass on cost shocks because
of the rise in intra-marginal costs.
It is difficult to come across unemployment estimates, but these
numbers are large. In the developed countries, output is regarded as below
potential because the crisis left 22 million unemployed. In India, the over
300 million below the poverty line are not meaningfully employed. Given
the youthful demographic profile, 10-12 million are expected to enter the
labour force every year. The Planning Commission estimates it will take
growth at 10 per cent per annum together with an employment elasticity of
0.25 to absorb them. Since peak levels of domestic savings plus inflows
had reached 40 percent of GPD, with an incremental capital output ratio of
4, this gives ten per cent rate of growth. This could be regarded as the
potential output. The RBI, however, defines full capacity as the potential
output of the small manufacturing sector, even though in India, for example,
this accounts for only 25 per cent of the output and 5 per cent of the
employment. The economy is considered to be supply constrained. Figure
1 helps understand how exactly the economy is supply constrained and
better captures the macroeconomic structure of an economy in transition.
The economy is supply-constrained in the sense inefficiencies on the supply
side perpetuate inflation although output is largely demand determined.
Demand contractions amplify shocks, but are not major independent sources
of shocks.
Political and institutional features also result in a fiscal-monetary
coordination such that the economy remains on an elastic stretch of the
aggregate supply curve. Fiscal populism pushes monetary authorities towards
conservatism in order to reduce inflationary expectations. But since the
populism raises inefficiencies and therefore costs it shifts up the supply
curve, while monetary tightening reduces demand, resulting in a large
negative effect on output for little gain in reduced inflation. For the RBI to
be accommodating, restraint on revenue deficits and populist expenditure is
necessary.
Outcomes 51
6 Trends in Money and Credit
The trends in money
25
over the decades demonstrate the policy issues
we have surveyed. Table 12 shows much more fluctuations in the rate of
growth of RM compared to other types of money. Rates of growth for all
types increased substantially after the first two decades, demonstrating the
increasing monetization of the economy. This was especially rapid from the
eighties as the jump in time deposit to GDP ratio, and of broad money, of
which it is a component, indicates. The jump in time deposit ratios reflects
the rise in savings ratios in the eighties to above 20 per cent (Table 4). The
expansion in bank branches partly caused this rise.
Table 12: Trends in Money
Reserve Narrow Broad Demand Time
Money Money Money Deposits Deposits
Average Annual Growth Rate
1951-52 to 1959-60 4.3 3.74 5.94 3.22 15.62
1960-61 to 1969-70 7.6 9.18 9.57 12.63 10.61
1970-71 to 1979-80 14.88 12.17 17.27 13.54 24.7
1980-81 to 1989-90 16.5 15.09 17.21 15.82 18.29
1990-91 to 1999-00 13.87 15.62 17.17 16.32 17.98
2000-01 to 2009-10 15.42 16.02 17.46 17.57 18.09
Average Ratio to GDP Market Price (percentage)
1951-52 to 1959-60 13.2 17.47 22.02 5.11 4.55
1960-61 to 1969-70 11.46 15.75 21.84 4.98 6.09
1970-71 to 1979-80 10.99 16.2 29.24 7.02 13.04
1980-81 to 1989-90 13.84 15.74 41.98 6.58 26.24
1990-91 to 1999-00 15.28 17.47 51.33 7.71 33.85
2000-01 to 2009-10 16.22 21.18 74.8 9.81 53.62
25
RBI definitions of reserve money from the components side are: Currency in
circulation + Banker’s deposits with the RBI+ other deposits with the RBI, and
from the sources side: RBI’s domestic credit + Govt’s currency liabilities to the
Public+Net FX assets of RBI other items. The definitions of broad money from
the components side are: Currency with the public + Aggregate deposits with
banks, and from the sources side are: Net bank credit to government (Net RBI
credit to central and state governments + other banks’ credit to government) +
Bank credit to commercial sector (RBI+ other banks) + Net forex assets of banking
sector (RBI+ other banks) + Government’s currency liabilities to the public -
banking sector’s net non-monetary liabilities. These were followed in deriving
the series given in the tables.
52 History of Monetary Policy in India
Table 13: Decadal Averages
D/R D/C Money M3/ GDP/
Multiplier RM M3
1953-54 to 1959-60 21.61 0.79 1.73 1.69 4.70
1960-61 to 1969-70 28.09 1.09 2.01 1.93 4.83
1970-71 to 1979-80 19.50 2.12 2.72 2.66 3.77
1980-81 to 1989-90 8.07 3.45 3.09 3.12 2.58
1990-91 to 1999-00 8.29 4.18 3.43 3.37 2.11
2000-01 to 2009-10 14.80 5.42 4.67 4.73 1.46
Table 13 presents select monetary ratios: The money multiplier
and its determinants; the aggregate deposits to bank reserves ratio (D/R);
aggregate deposits to currency ratio (D/C). Currency and reserves are the
quantity variables that can be affected by the CB. For example, the CB
can increase currency by printing more money and it can similarly increase
reserves by requiring a higher percentage of deposits to be stored in the
CB.
The steady rise in D/C also reflects monetization of the economy.
It also demonstrates confidence in the financial system, and the absence of
inflation high enough to induce a flight from money. The fall in D/R from
the 1970s was a consequence of the sharp rise in CRR. This was unable to
prevent a rise in M/RM but it did slow down its increase in the eighties and
nineties compared to the last decade. The last column GDP/M is a measure
of velocity. The latter fell through all the decades, showing a well-managed
financial expansion, and a positive income elasticity of money demand
26
.
Income elasticity was rising because of expansion of bank branches but
lack of other financial instruments, probably tended to decrease it. GDP/M
did rise for a few years in the inflationary seventies, as did the GDP/C
ratio. The GDP of the nation rose as it became a trillion dollar plus economy.
But the stock of money, essential for lubricating commerce, rose even faster.
26
In the US, for example, velocity fell until 1948, the period of expansion of banks,
and rose after that.
Outcomes 53
T
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1
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7
54 History of Monetary Policy in India
Table 14 shows the creation of credit, on which the monetary policy
was explicitly focused for much of the period. The steepest rise in credit/
GDP ratios came, however, after liberalization. India’s credit/GDP ratio is
low by world standards and must rise. But a sudden sharp rise often leads
to a financial crisis. Rates of growth of credit were however always
moderate. Also noteworthy, in Table 14, is the sharp fall in RBI’s credit to
the Government, following the termination of ad hoc treasury bills, and the
imperatives of sterilization of large inflows. Other bank credit to the
Government rose. Banks often voluntarily held Gsecs in excess of lowered
SLR requirements, as rates and returns became attractive.
Table 15: Effects of Reserve Accumulation
Decades Ratio of Net Ratio of Share of G Share of Change in
Domestic Net Foreign Securities Commercial Forex
Assets of the Assets of the in Other Credit in Reserves
RBI to RM RBI to RM Bank Credit Other Bank as a Ratio
Credit of Current
Account
of BOP
Percentage Percentage (+, increase)
1960-61 to 1969-70 5.45 24.17 75.83 0.098
1970-71 to 1979-80 80.35 19.65 20.13 79.87 0.641
1980-81 to 1989-90 89.33 10.67 21.04 78.96 -0.069
1990-91 to 1999-00 62.13 37.87 29.5 70.5 1.69
2000-01 to 2009-10 -3.92* 108.56 33.36 66.63 1.42
Although the size of the retail Gsecs market had seen a large rise,
the fear of adversely affecting rates and increasing the cost of Government
borrowing restrained the RBI’s use of OMOs. Complicated restraints on
Gsecs and split between capital and interest with mark to market only for
the part not held to maturity continued to make Gsecs attractive to banks
and to prevent them from selling when they could make capital gains. The
need for such complicated restraints will reduce as a smaller share of held
to maturity category and more interest rate volatility forces banks to hedge
interest rate risks. Apart from OTC derivatives, markets for interest rate
futures have also been developed.
Creating retail depth in the holding of Gsecs, and reducing the relative
size of government borrowing from the domestic financial sector, will help
the RBI to move more fully towards interest rate rather than money supply
or credit variables as instruments. A push for change will come from the
new Basel III prudential norms, which are unlikely to accept a forced
statutory holding of even A class securities as providing a liquidity buffer.
Outcomes 55
The new IFRS accounting norms will also require marking holdings of Gsecs
to market.
In advanced countries as debt shares declined, independent debt
management offices were created. It was thought separating monetary
policy from the management of the Government debt, would reduce conflicts
of interest. India was set to also follow this reform path. But as post crisis
debt levels in these countries rose sharply CBs market tactics ca be important
in maintaining the confidence of market participants and smooth functioning
of debt markets (Goodhart 2010). Given the relatively high levels of
Government debt, the RBI had long been using such tactics to manage
government borrowing requirements. Other countries seem to be converging
to India’s current practices even as India tries to converge to earlier norms.
This underlines again that market development cannot mean blindly aping
practices elsewhere. Adapting to local needs and structure is important.
Table 15 shows the rising share of Gsecs in the commercial banks
portfolio, and the consequent fall in share of commercial credit. The
contribution of net domestic assets (NDA) to RM became negative as
large net foreign assets (NFA) displaced them in the RBI’s balance sheet.
Additions to foreign exchange reserves, driven by capital flows, exceeded
the current account by a large margin. Since reserves responded to volatile
inflows on the capital account, while the current account was in deficit,
they were a valid precautionary measure.
VI. CONCLUSION
Money and monetary policy are slippery concepts, and reality is
often not what it seems on a surface reading. But careful fact-based analysis
can yield interesting insights. There is two-way causality between money
and nominal income. But during large supply shocks, policy shocks can be
treated as exogenous. Such shocks are used in this study to understand the
structure of the economy. These suggest that policy was sometimes
exceedingly tight when the fear, and the common understanding, was
opposite: of a large monetary overhang. In focusing on financing the
Government, rather than on domestic cycles, policy was procyclical—too
accommodative in good times and tight in bad times.
Fiscal dominance pushed monetary policy to be too tight or too
loose to compensate. An intellectual climate that encouraged government
intervention and advocated a big push for development favoured the
dominance of fiscal policy. These ideas became embedded in institutions
and created path dependence—it was difficult to break out on a new path.
The balance of payments crisis and the change in intellectual ideas provided
the opportunity. The initial swing was too much in favour of markets, but a
series of international currency and financial crisis have helped to moderate
orthodoxy. It has become possible to devise a middling through path that
suits Indian democracy and structure. The global crisis evoked a refreshing
and apt policy stance that helped the economy retain high growth. But
improvements are still required in inflation management.
When the dominant ideas of the time supported closed capital-
intensive import-substituting growth, Vakil and Brahmananda (1956) pointed
out the importance of the wage goods constraint. Relieving the latter required
more attention on increasing agricultural productivity and on openness. But
the closing of the economy that condemned India to many years of stagnation
happened because intellectual opinion was too susceptible to external ideas,
and neglected more robust ideas based on a close understanding of own
context.
The currently dominant ideas, favouring gradual liberalisation, should
aid India in its catch-up period of high growth and beyond, providing high
productivity employment for its billion plus people. But that tailoring to
context continues to be required. A non-ideological middling through approach
makes a pragmatic adaptation to context possible. For monetary policy the
three factors that cause a loss of autonomy—governments, markets and
openness—are conveniently moderating each other. Thus markets are
Conclusion 57
moderating fiscal profligacy; crises are moderating markets and openness.
And institutions are slowly strengthening in adapting to the new ideas.
The many changes recorded in this history, demonstrate the dynamism
displayed by the economy, its institutions and policy, countering the argument
that democracies are doomed to stagnation. An example of change is the
behaviour of interest rates. Although liberalisation initially increased the
volatility of rates in a thin market, it eventually brought down the volatility
to levels prevailing when rates were tightly administered, as markets
deepened. But now the rates came through a robust interaction between
markets, institutions and policy.
In the mid-nineties, in thin markets and with greater monetary
autonomy combined with unhealthy government finances, there were sharp
peaks in policy and market rates that hurt growth. But after the global
financial crisis, when fiscal responsibility legislation, higher growth and better
tax administration had improved government finances, monetary-fiscal
coordination was better and India came through in good shape. The future
will see these years as transformative for India and its institutions. Sometimes
the best haste is made slowly.
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ABOUT THE AUTHOR
Ashima Goyal, Professor at IGIDR, Mumbai, is widely published in
institutional and open economy macroeconomics, international finance and
governance and has participated in research projects with ADB, DEA,
GDN, RBI, UN ESCAP and WB. She is co-editor of a Routledge journal in
macroeconomics and international finance for emerging markets. She has
received many fellowships, national and international awards and is active
in the Indian public debates. She has served on several boards and policy
committees and is currently a member of the Monetary Policy Technical
Advisory Committee. She contributes a monthly column to The Hindu
Business Line. She has been a visiting fellow at the Economic Growth
Centre, Yale University, USA, and a Fulbright Senior Research Fellow at
Claremont Graduate University, USA. More details are available at http://
www.igidr.ac.in/faculty/ashima/
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